SM ch10

CHAPTER 10
QUESTIONS
1. The major components included in the
FASBs definition of liabilities are as
follows:
(a) A liability is a result of past
transactions or events.
(b) A liability involves a probable future
transfer of assets or services.
(c) A liability is the obligation of a
particular entity.
All of these components should be present
before a liability is recorded. In addition,
the amount of the liability must be
measurable in order to report it on the
balance sheet.
4. Generally, liabilities should be reported at

their net present values rather than at the
amounts that eventually will be paid. The
use of money involves a cost in the form of
interest that should be recognized whether
or not such cost is expressly stated under
the terms of the debt agreement. A debt of
$10,000 due 5 years from now has a
present value less than $10,000, unless
interest is charged on the $10,000 at a
reasonable rate.
5. Some companies include short-term
borrowing as a permanent aspect of their
overall financing mix. In such a case, the
company often intends to renew, or roll
over, its short-term loans as they become
due. As a result, a short-term loan can take
on the nature of a long-term debt because,
with the refinancing, the cash payment to
satisfy the loan is deferred into the future.
As of the date the financial statements are
issued, if a company has either already
done the refinancing or has a firm
agreement with a lender to refinance a
short-term loan, the loan is classified in the
balance sheet as a long-term liability.
6. A line of credit is a negotiated arrangement
with a lender in which the terms are agreed
to prior to the need for borrowing. When a
company finds itself in need of money, an
established line of credit allows the
company access to funds immediately
without having to go through the credit
approval process.
7. In reporting long-term debt obligations, the
emphasis is on reporting what the real
economic value of the obligation is today,
not what the total debt payments will be in
the future. The sum of the future cash
payments to be made on a long-term debt
is not a good measure of the actual
economic obligation. Because the cash
outflows associated with a long-term
liability extend far into the future, presentvalue concepts must be used to properly
value the liability.
2. a. An executory contract is one in which

performance by both parties is still in
the future. Only an exchange of
promises is made at the initiation of the
contract. Common examples include
labor contracts and purchase orders.
b. The definition of liability states in part
that a liability should be the result of a
past transaction or event. Similar
concepts in previous definitions used
by accounting bodies have excluded
executory contracts from inclusion as
liabilities. However, the accounting
methods currently accepted for leases,
for example, essentially recognize
liabilities before performance by either
party to the lease contract. Thus, the
FASB apparently does not feel that its
definition excludes the possibility of
recording executory contracts as
liabilities.
3. Current liabilities are claims arising from
operations that must be satisfied with
current assets within 1 operating cycle or
within 1 year, whichever is longer. Nonoperating cycle claims are classified as
current if they must be paid within 1 year
from the balance sheet date.
Noncurrent liabilities are liabilities whose
liquidation will not require the use of
current assets to satisfy the obligation
within 1 year.
187
188
Chapter 10
8.
For each payment, a portion is interest and

the remainder is applied to reduce the
principal. To compute the amount
attributable to principal, the outstanding
loan balance is multiplied by the monthly
interest rate. The result is the interest
portion of the payment. Subtracting this
amount from the total payment gives the
amount applied to reduce the principal.
9.
a. Secured bonds have specific assets

pledged as security for the issue.
Unsecured bonds, frequently referred
to as debenture bonds, are not
protected by the pledge or mortgage of
specific assets.
b. Collateral trust bonds are secured by
stocks and bonds owned by the
borrowing corporation. There is no
specific pledge of property in the case
of debenture bonds, the issue being
secured only by the general credit of
the
company.
c. Convertible bonds may be exchanged
at the option of the bondholder for
other securities of the corporation in
accordance with the provisions of the
bond contract. Callable bonds may be
redeemed by the issuing company
before maturity at a specified price.
d. Coupon bonds are not recorded in the
name of the owner, and title passes
with delivery of the bond. Interest is
paid by having the bondholder clip the
coupons attached to the bonds and
present these for payment on the
interest dates. Registered bonds call
for the registry of the bondholders
name on the books of the corporation.
Transfer of title to these bonds is
accomplished by surrender of the old
bond certificates to the transfer agent,
who records the change in ownership
and issues new certificates to the
buyer. Interest checks are periodically
prepared and mailed to the holders of
record.
e. Municipal bonds are issued by
governmental units, including state,
county, and local entities. The
proceeds are used to finance
expenditures
such
as
school
construction, utility lines, and road
construction. The bonds normally sell
at lower interest rates than do other
f.
bonds because of the favorable tax

treatment given to the holders of the
bonds for the interest received.
Because the interest revenue is not
taxed by the federal government, these
bonds are frequently referred to as taxexempt securities. Corporate bonds are
issued by corporations as a means of
financing their long-term needs.
Corporations usually have a choice of
raising long-term capital through
issuing bonds or stock. Bonds have a
fixed interest rate while stock pays its
return through declared dividends. The
holders of corporate bonds must pay
federal income taxes on interest
revenue received.
Term bonds mature as a lump sum on
a single date. Serial bonds mature in
installments on various dates.
10. The market rate of interest is the rate

prevailing in the market at the moment.
The stated rate of interest is the rate
printed on the face of the bonds. This is
also known as the contract rate. The
effective or yield rate of interest is the
same as the market rate at date of
issuance (purchase) and is the actual
return on the purchase price received by
the investor and incurred by the issuer.
The market rate fluctuates during the life of
the bonds in accordance with economywide
changes in expectations about future
inflation and with the changing financial
condition of the company; the stated rate
remains the same. Although the effective
rate remains the same for the individual
bond investor or the borrowing corporation
over the life of the issue, this rate will vary
from one bondholder to another when the
securities are acquired at different times
and prices.
11. APB Opinion No. 21 recommends the use
of the effective-interest method of
amortization for bond premiums and
discounts. Because the effective-interest
method adjusts the stated interest rate to
the effective rate, it is theoretically more
accurate than the straight-line method. It
was therefore designated by the APB as
the preferred method of amortization. The
straight-line method may be used if the
interim results of using it do not differ
materially from the resulting amortization
Chapter 10
using the effective-interest method. The

total amortization will, of course, be the
same under either method over the life of
the bond.
189
12. Three ways bonds may be retired prior to

maturity are as follows:
(a) Bonds
may
be
redeemed
by
purchasing them on the open market or
by exercising the call provision if
included in the bond indenture.
(b) Bonds may be converted or exchanged
for other securities.
(c) Bonds may be refinanced (sometimes
called refunded) with the use of
proceeds from the sale of a new issue.
Normally, with the early extinguishment of
a debt, a gain or loss must be recognized
for the difference between the carrying
value of the debt security and the amount
paid. Before FASB Statement No. 145, this
gain or loss would have been labeled as an
early extinguishment of debt and reported
as an extraordinary item on the income
statement. Now it is typically reported as
an ordinary item.
13. Callable bonds serve the issuers interests
because the callability feature enables the
issuing
corporation
to
reduce
its
outstanding indebtedness at any time that it
may be convenient or profitable to do so.
14. Convertible debt securities generally have
the following features:
(a) An interest rate lower than the issuer
could establish for nonconvertible debt.
(b) An initial conversion price higher than
the market value of the common stock
at time of issuance.
(c) A call option retained by the issuer.
These securities raise many questions as
to the nature of the securities. Examples of
these questions include whether they
should be considered debt or equity
securities, the valuation of the conversion
feature, and the treatment of any gain or
loss on conversion.
15. Under IFRS 32, the issuance proceeds are
allocated between debt and equity for all
convertible debt issues. Under U.S. GAAP,
this allocation is done only when the
conversion feature is detachable.
16. Convertible bonds are securities that may
be viewed either as primarily debt or
primarily equity. If they are viewed as debt,
the conversion from debt to equity could be
considered a significant economic event for
which any difference between current
market price for the securities and their
carrying value should be recognized as a
190
Chapter 10
gain or loss. For the investor, this could be

viewed as the exchange of nonmonetary
assets. For the issuer, this could be viewed
as creating a significant difference in the
type of ownership being assumed.
On the other hand, if the convertible bonds
are considered as primarily equity
securities whose market is responsive to
the price of common stock, the exchange
of one equity security for another could be
considered as not a significant exchange,
and under the historical cost concept, it
should not give rise to any gain or loss.
17. Bond refinancing or refunding means
issuing new bonds and applying the
proceeds to the retirement of outstanding
bonds. This may occur either at the
maturity of the old bonds or whenever it
may be advantageous to retire old bonds
by issuing new bonds with a lower interest
rate, a more favorable bond contract, or
some other benefit.
18. Avoiding the inclusion of debt on the
balance sheet through the use of offbalance-sheet financing may allow a
company to borrow more than otherwise
possible due to debt-limit restrictions. Also,
a strong appearance of a companys
financial position usually enables it to
borrow at a lower cost. Another possible
reason is that companies wish to
understate liabilities because inflation has,
in effect, understated its assets.
One of the main problems with off-balancesheet financing is that many investors and
lenders arent able to see through the offbalance-sheet borrowing tactics and
thereby make ill-informed decisions. There
is also concern that as these methods of
financing gain popularity, the amount of
total corporate debt is reaching unhealthy
proportions.
19. If a special-purpose entity (SPE) is
carefully designed, it can be accounted for
as an
independent company, and any
debt that it incurs will not be reported in the
balance sheet of its sponsor.
20. Companies will, on occasion, join forces
with other companies to share the costs
and benefits associated with specifically
defined projects. These joint ventures are
often developed to share the risks
associated with high-risk projects. Because
the benefits of these joint ventures are

uncertain, companies have the possibility
of incurring substantial liabilities with few, if
any, assets resulting from their efforts. As
a result, as is the case with unconsolidated
subsidiaries, a joint venture is carefully
structured to ensure that the liabilities of
the joint venture are not disclosed in the
balance sheets of the companies in the
partnership. Often, both joint venture
partners account for the joint venture using
the equity method; that is, the liabilities of
the joint venture are not included in the
balance sheets of the partners.
21. Troubled debt restructuring occurs when the
investor (creditor) is willing to make
significant concessions as to the return
from the investment in order to avoid
making
settlement
under
adverse
conditions, such as bankruptcy. This
means that if the restructuring involves a
significant transaction, the investors
(creditors)
will
almost
always
report a loss unless they have previously
anticipated the loss and have reduced the
investment to a value lower than the
amount
finally
determined
in
the
settlement. The issuer will report a gain if
the restructuring involves a significant
transaction.
Relates to Expanded Material

22. a. A bond restructuring involving an asset
swap usually results in a recognition of
a loss on the investors books and a
gain on the issuers books. The market
value of the assets swapped usually
determines the amount of gain or loss
to be recognized. Only if the market
value of the retired debt is more clearly
determinable would such a value be
used.
b. A bond restructuring involving an
equity swap similarly results in
recognition of gains or losses because
the market value of the equity
exchanged for the debt is used to
record the transaction. If the market
value of the debt is more clearly
determinable than the market value of
the equity, the value of the debt would
be used.
c. A bond restructuring involving a
modification of terms does not result in
Chapter 10
recognition of a gain or loss unless the

total amount of future cash to be paid,
principal plus interest, is less than the
carrying value of the debt. In that case,
the difference between the future cash
191
and the carrying value is recognized as

a gain or loss. Under this condition,
future cash payments are charged to
the liability account on the issuers
books.
PRACTICE EXERCISES
PRACTICE 101
Current assets:
Current liabilities:
WORKING CAPITAL AND CURRENT RATIO

Cash
Accounts receivable
Total
$ 400
1,750
$2,150
Accounts payable
Accrued wages payable
Deferred sales revenue
Bonds payable (to be repaid in 6 months)
Total
$1,100
250
900
1,000
$3,250
Working capital = Current assets Current liabilities = $2,150 $3,250 = ($1,100)

Current ratio = Current assets/Current liabilities = $2,150/$3,250 = 0.66
PRACTICE 102
SHORT-TERM OBLIGATIONS EXPECTED TO BE REFINANCED

Loan A
Loan B
Loan C
Total
PRACTICE 103
Current Liabilities
$10,000
15,000
2,500
$27,500
TOTAL COST OF LINE OF CREDIT
Credit line commitment fee: $100,000 0.0008 (12/12) = $80

Interest: $70,000 0.064 (8/12) = $2,987
$2,987 + $80 = $3,067
PRACTICE 104
COMPUTATION OF MONTHLY PAYMENTS
Business Calculator Keystrokes:

PV = $300,000 (1 0.10) = $270,000
N = 30 years 12 = 360
I = 7.5/12 = 0.625
FV = 0 (there is no balloon payment associated with the mortgage)
PMT = $1,887.88
Noncurrent Liabilities
$
0
0
17,500
$17,500
PRACTICE 105
PRESENT VALUE OF FUTURE PAYMENTS
PMT = $1,887.88 (see the solution to Practice 104)

Business Calculator Keystrokes:
N = 30 years 12 = 360 12 payments made = 348 payments remaining
I = 7.5/12 = 0.625
PMT = $1,887.88
FV = 0 (no balloon payment is associated with the mortgage)
PV = $267,511
PRACTICE 106
MARKET PRICE OF A BOND
N = 20 years 2 = 40
I = 14/2 = 7
PMT = $1,000 0.10 (1/2) = $50
FV = $1,000 (the face value is paid at the end of 20 years)
PV = $733.37
PRACTICE 107
MARKET PRICE OF A BOND
N = 10 years 2 = 20
I = 8/2 = 4
PMT = $1,000 0.13 (1/2) = $65
FV = $1,000 (the face value is paid at the end of 10 years)
PV = $1,339.76
PRACTICE 108
ACCOUNTING FOR ISSUANCE OF BONDS
Cash
1,030
Premium on Bonds Payable
Bonds Payable
PRACTICE 109
30
1,000
ACCOUNTING FOR ISSUANCE OF BONDS
Cash
Discount on Bonds Payable
Bonds Payable
920
80
1,000
PRACTICE 1010 BOND ISSUANCE BETWEEN INTEREST DATES

Cash
100,750
Bonds Payable
Interest Payable [$100,000 0.09 (1/12)]
100,000
750
194
Chapter 10
PRACTICE 1011 STRAIGHT-LINE AMORTIZATION

June 30
Interest Expense
Cash [$100,000 0.08 (6/12)]
4,512.40
512.40
4,000.00
Discount on Bonds Payable = ($100,000 $84,628)/30 = $512.40

December 31
Interest Expense
Cash [$100,000 0.08 (6/12)]
4,512.40
512.40
4,000.00
PRACTICE 1012 EFFECTIVE-INTEREST AMORTIZATION

June 30
Interest Expense ($84,628 0.05)

Cash [$100,000 0.08 (6/12)]
4,231.40
231.40
4,000.00
Remaining carrying value of bond: $84,628.00 + $231.40 = $84,859.40

December 31
Interest Expense ($84,859.40 0.05)
Cash [$100,000 0.08 (6/12)]
4,242.97
242.97
4,000.00
Remaining carrying value of bond: $84,859.40 + $242.97 = $85,102.37

PRACTICE 1013 BOND PREMIUMS AND DISCOUNTS ON THE CASH FLOW STATEMENT
Sales
Interest expense
Net income
Income Statement
$42,000
Adjustments
0
Subtract Amortization of
Bond Premium
(4,650)
$37,350
(350)
1.
Direct Method:
Cash collected from customers
Cash paid for interest
Net cash flow from operating activities
$42,000
(5,000)
$37,000
2.
Indirect Method:
Net income
Less: Amortization of bond premium
Net cash flow from operating activities
$37,350
(350)
$37,000
Statement of
Cash Flows
$42,000
(5,000)
$37,000
PRACTICE 1014 MARKET REDEMPTION OF BONDS

1.
2.
Bonds Payable
Loss on Bond Redemption
Cash
100,000
4,700
Bonds Payable
Loss on Bond Redemption
Cash
100,000
2,000
700
2,000
102,700
102,700
PRACTICE 1015 ACCOUNTING FOR ISSUANCE OF CONVERTIBLE BONDS

If the conversion feature is accounted for separately, the journal entry is as follows:
Cash
Bonds Payable
Paid-In Capital from Conversion Feature
107,000
2,000
100,000
9,000
If the conversion feature is not accounted for separately, the journal entry is as follows:
Cash

Bonds Payable
107,000
7,000
100,000
PRACTICE 1016 ACCOUNTING FOR CONVERSION OF CONVERTIBLE BONDS

Bonds Payable
Loss on Bond Conversion
Common Stock, $1 par
Paid-In Capital in Excess of Par
100,000
11,500
Paid-in capital in excess of par = ($55 $1 par) 2,000 = $108,000

PRACTICE 1017 DEBT-TO-EQUITY RATIO
1.
Debt = All liabilities
Debt-to-equity ratio = $120,000/$90,000 = 1.33

2.
Debt = All interest-bearing debt
Debt-to-equity ratio = ($10,000 + $70,000)/$90,000 = 0.89

3.
Debt = Long-term, interest-bearing debt
Debt-to-equity ratio = $70,000/$90,000 = 0.78

PRACTICE 1018 TIMES INTEREST EARNED RATIO
1,500
2,000
108,000
196
Chapter 10
Times interest earned ratio

= Earnings before interest and taxes/Interest expense
= ($12,000 + $7,500)/$7,500
= 2.60
PRACTICE 1019 DEBT RESTRUCTURING: ASSET SWAP
Bonds Payable
Interest Payable
Land
Gain on Disposal of Land
Gain on Debt Restructuring
100,000
3,000
6,000
64,000
26,000
19,000
PRACTICE 1020 DEBT RESTRUCTURING: EQUITY SWAP

Bonds Payable
100,000
Interest Payable
5,000
4,000
Common Stock at Par (10,000 shares $1)
10,000
Paid-In Capital in Excess of Par ($90,000 $10,000)
Gain on Debt Restructuring
11,000
80,000
PRACTICE 1021 DEBT RESTRUCTURING: SUBSTANTIAL MODIFICATION

1.
Undiscounted sum of payments to be made:
Maturity value
Annual interest payments (5 $800)
Total
$5,000
4,000
$9,000
Because this $9,000 amount is less than the carrying value of $10,800 ($10,000 + $800 in accrued interest), the
loan modification is classified as substantial, and the following journal entry is made:
Interest Payable
Loan Payable
Gain on Restructuring of Debt
Restructured Debt
800
10,000
1,800
9,000
2.
Next years interest expense:
$0. The implicit interest rate on the loan is now 0% because the terms were modified substantially, necessitating a
reduction in carrying value. In a case such as this, there is no interest expense in subsequent years, only a reduction
in principal as the loan carrying value is reduced.
PRACTICE 1022 DEBT RESTRUCTURING: SLIGHT MODIFICATION

1.
Undiscounted sum of payments to be made:
Maturity value
Annual interest payments (5 $800)
Total
$ 8,000
4,000
$12,000
Because this $12,000 amount exceeds the carrying value of $10,800 ($10,000 + $800 in accrued interest), the loan
modification is classified as slight, and no journal entry is made. One might consider making the following
reclassification entry:
Interest Payable
800
Loan Payable
10,000
Restructured Debt
10,800
2.
Next years interest expense
A new implicit interest rate on the loan must be computed, as follows. [Note: For a review of the computation of
implicit interest rates (internal rates of return), refer to Appendix B.]
PV = $10,800 (this is the new carrying value of the loan; enter as a negative number)
PMT = $0 (no annual payments will be made)
FV = $12,000
N = 4 (the total loan term is 5 years; 1 year has elapsed already)
I = ???; the solution is 2.67%.
Next years interest expense = $10,800 0.0267 = $288.36
198
Chapter 10
EXERCISES
1023.
1.
Feb. 1, 2005
Interest expense:
$640,000 0.10 1/12 = $5,333.33
Reduction to principal: $5,616.46 $5,333.33 = $283.13
Interest expense: ($640,000 $283.13) 0.10 1/12 = $5,330.97
Reduction to principal: $5,616.46 $5,330.97 = $285.49
Mar. 1, 2005
2.
Feb. 1, 2005 Interest Expense.................................................
Mortgage Payable...............................................
Cash................................................................
1024.
1.
Month
Monthly
Payment
Principal
Paid
Interest
Paid
July
August
September
October
November
December
Totals
$ 1,112
1,112
1,112
1,112
1,112
1,112
$ 6,672
$ 612
618
624
631
637
643
$ 3,765
$ 500
494
488
481
475
469
$ 2,907
5,333.33
283.13
5,616.46
Balance
$50,000
49,388
48,770
48,146
47,515
46,878
46,235
2.
Interest expense of $2,907 will be reported in 2005.
3.
A mortgage liability of $46,235 ($50,000 $3,765) will be reported on the balance

sheet at the end of 2005.
1025.
(a) Present value of maturity value:

Maturity value of bonds after 10 years or 20
semiannual periods............................................................
Effective interest rate12% per year, or 6% per
semiannual period:
PVn = $1,000,000(Table II
= $1,000,000(0.3118)
= $311,800
$1,000,000
20 6% )
or with a business calculator:

FV = $1,000,000; N = 20; I = 6% PV = $311,805
Present value of 20 interest payments:
Semiannual payment, 5% of $1,000,000..............................
1025.
(Continued)
$ 50,000
semiannual period:
PVn = $50,000(Table IV
= $50,000(11.4699)
= $573,495
20 6% )

PMT = $50,000; N = 20; I = 6% PV = $573,496
Market price: $311,800 + $573,495 = $885,295
(b) Present value of maturity value:
semiannual period:
PVn = $200,000(Table II
= $200,000(0.6756)
= $135,120
$200,000
10 4% )

FV = $200,000; N = 10; I = 4% PV = $135,113
Semiannual payment, 4.5% of $200,000..............................
semiannual period:
PVn = $9,000(Table IV
= $9,000(8.1109)
= $72,998
9,000
10 4% )

PMT = $9,000; N = 10; I = 4% PV = $72,998
Market price: $135,120 + $72,998 = $208,118
(c) Present value of maturity value:
semiannual period:
$150,000
200
Chapter 10
1025. (Concluded)
PVn
= $150,000(Table II 25 5% )
= $150,000(0.2953)
= $44,295
FV = $150,000; N = 25; I = 5% PV = $44,295
Semiannual payment, 4% of $150,000.................................
semiannual period:
$ 6,000
PVn = $6,000(Table IV 25 5% )
= $6,000(14.0939)
= $84,563
PMT = $6,000; N = 25; I = 5% PV = $84,564
Market price: $44,295 + $84,563 = $128,858
1026.
(a) Pop-ups bonds sold at a premium because the stated rate of interest
was above the market rate at the issuance date.
(b) Splendors bonds sold at a discount. They sold at an interest rate that
had a yield above the stated rate.
(c) Cards bonds sold at a discount because the contract rate was below
the effective rate.
(d) Floppys bonds sold at a premium because the stated rate was above
the market rate at the date of issuance.
(e) Cintrons bonds sold at par because the contract and the effective rates
were the same at the date of issuance.
1027.
(a) Because the market rate equals the stated rate, the face value of the
bond will equal the market value of the bond. In this case, a bond
issuance with a face value of $50 million will result in cash to Allrite of
$50 million. The associated journal entry would be
Cash.....................................................................
Bonds Payable...............................................
50,000,000
50,000,000
10-27. (Concluded)
b. Because this zero-coupon bond has no interest annuity associated with
it, students must use only Table II to determine the face value of the
bond issuance. Using the column associated with an interest rate of 5%
(assuming that the market interest rate is still 10% compounded semiannually) and the row associated with 20 periods results in a factor of
0.3769. Using this factor to determine the face value of the required
bond issuance results in a face value computed as follows:
$50,000,000 0.3769 = $132,661,183
PV = $50,000,000; N = 20; I = 5% FV = $132,664,885
Thus, to receive proceeds from the bond sale of $50,000,000, Allrite
would have to issue zero-coupon bonds with a face value of
approximately $132,661,183. The related journal entry would be
Cash..................................................................... 50,000,000
Discount on Bonds Payable............................... 82,661,183
Bonds Payable..................................................
132,661,183
1028.
(1) 2004
Jan. 1 Cash.................................................................
Bonds Payable............................................
Premium on Bonds Payable......................
To record sale of $500,000, 10%,
10-year bonds at 102.
(2) 2004
July 1 Interest Expense.............................................
Premium on Bonds Payable ($10,000 10
years 6/12)..................................................
Cash ($500,000 0.10 6/12).....................
To record interest paid and premium
amortization for 6 months.
Dec. 31 Interest Expense.............................................
Premium on Bonds Payable..........................
Interest Payable..........................................
To record accrued interest and
premium amortization for 6 months.
510,000
500,000
10,000
24,500
500
25,000
24,500
500
25,000
202
Chapter 10
1028. (Concluded)
(3) 2005
Apr. 1 Premium on Bonds Payable..........................
25*
Interest Expense.........................................
To record premium amortization
on 50 bonds for 3 months.
*Premium amortization = 1/1 thru 4/1 on bonds retired
($50,000 $500,000 3/120 $10,000 = $25)
25
Interest Expense ($50,000 0.10 3/12).......

1,250*
1,250
To record interest on 50 bonds for
3 months.
Bonds Payable................................................
50,000
Interest Payable..............................................
1,250
875*
Cash.............................................................
50,250
Gain on Bond Redemption.........................
1,875
*Unamortized premium written off (105 months early):
$50,000 $500,000 105/120 $10,000 = $875
Cash paid:
$50,000 0.98 = $49,000 + $1,250 Accrued interest =
$50,250
Gain on bond reacquisition:

Carrying value ($50,000 + $875) Amount paid ($49,000) =
$1,875
(4) 2005
July 1 Interest Expense.............................................
($9,000 10 years 6/12)............................
Cash ($450,000 0.10 6/12).....................
To record interest paid and premium
amortization for 6 months for the
remaining bonds $450,000 out of
$500,000, or 90%.
Dec. 31 Interest Expense.............................................
To record accrued interest and
premium amortization for 6 months
for the remaining bonds.
22,050
450
22,500
22,050
450
22,500
1029.
(1) Straight-Line Method:

The amount of discount amortized under the straight-line method is the
same for all years: $6,500 discount 12/120 = $650.
b. Effective-Interest Method:
2004
July 1 Interest amount based on effective rate
($93,500 0.045).........................................................
Interest payment based on stated rate
($100,000 0.04).........................................................
Difference between interest amount based on
effective rate and stated rate....................................
Interest Expense...................................
Discount on Bonds Payable.............
Cash...................................................
$4,217
4,000
$ 217
4,217
217
4,000
$4,227
4,000
$ 227
4,227
227
4,000
Dec. 31 Interest amount based on effective rate

($94,152 0.045).........................................................
($100,000 0.04).........................................................
Cash...................................................
$ 208
208
4,000
2005
July 1 Interest amount based on effective rate
($93,925 0.045).........................................................
($100,000 0.04).........................................................
Cash...................................................
4,000
4,208
Dec. 31 Interest amount based on effective rate

($93,708 0.045).........................................................
($100,000 0.04).........................................................
Cash...................................................
$4,208
$4,237
4,000
$ 237
4,237
237
4,000
204
1030.
Chapter 10
1. Investors Books:
a. Cash...........................................................................
Bond InvestmentBaker School District...............
Interest Revenue...................................................
*Discount amortization:
Discount: $200,000 $185,788 = $14,212
($14,212 10) 6/12 = $711
Cash...........................................................................
6,000
711*
6,711
6,000
711
6,711
b. Cash...........................................................................
6,000
503*
$185,788 0.035 = $6,503 (interest using effective rate)
$6,503 $6,000 = $503
Cash...........................................................................
$185,788 + $503 = $186,291
$186,291 0.035 = $6,520
$6,520 $6,000 = $520
2. Issuers Books:
a. Interest Expense.......................................................
Cash.......................................................................
Discount on Bonds Payable................................
1031.
6,503
6,000
520*
6,520
6,711
6,000
711
Interest Expense.......................................................
Cash.......................................................................
6,711
b. Interest Expense.......................................................
Cash.......................................................................
6,503
Cash.......................................................................
6,520
1. a. Interest Expense.......................................................
9,544
6,000
711
6,000
503
6,000
520
1,544*
Cash.......................................................................
8,000
$200,000 $184,556 = $15,444 (rounded)
$15,444 10 semiannual interest periods = $1,544 (rounded)
2.
Cash.......................................................................
9,544
Cash.......................................................................
$184,556 0.05 = $9,228
$9,228 $8,000 = $1,228
Cash.......................................................................
$184,556 + $1,228 = $185,784
$185,784 0.05 = $9,289
$9,289 $8,000 = $1,289
9,228
Cash...........................................................................
Bond InvestmentRolstone Corp..........................
Cash...........................................................................
Bond InvestmentRolstone Corp..........................
8,000
1,544
3. a. Interest Expense.......................................................
Premium on Bonds Payable....................................
Cash.......................................................................
*Premium amortization:
$217,062 $200,000 = $17,062
$17,062 10 = $1,706 (rounded)
Cash.......................................................................
1,544
8,000
1,228*
8,000
9,289
1,289*
8,000
9,544
8,000
1,544
9,544
6,294
1,706*
8,000
6,294
1,706
8,000
206
Chapter 10
1031. (Concluded)
Cash.......................................................................
$217,062 0.03 = $6,512 (rounded)
$8,000 $6,512 = $1,488 (rounded)
Cash.......................................................................
6,512
1,488*
8,000
6,467
1,533*
8,000
$217,062 $1,488 = $215,574
$215,574 0.03 = $6,467 (rounded)
$8,000 $6,467 = $1,533
1032.
2005
Feb. 1 Interest Receivable.........................................
Interest Revenue.........................................
To recognize 1 months accrued interest
($50,000 0.09 1/12). (Assumes accrual
of 4 months interest on 12/31/04 and no
reversing entry on 1/1/05.)
375
375
Bond InvestmentOldtown Corp..................

Interest Revenue.........................................
To recognize 1 months amortization of
discount ($4,000 1/86). (Assumes
amortization of discount on 12/31/04.)
47
Cash.................................................................
Bond InvestmentOldtown Corp.............
Gain on Sale of Bond Investment..............
Interest Receivable ($1,500 from
previous period)........................................
To recognize sale of investment at 97
plus accrued interest for 5 months
(no reversal at 1/1/05).
50,375
47
*Carrying value of bond investment:
Original cost................................................ $46,000

Amortization of discount ($4,000 31/86)
1,442
$47,442
Gain on sale:
Sale price..................................................... $48,500
Carrying value............................................. 47,442
Gain.............................................................. $ 1,058
47,442*
1,058
1,875
1032.
(Concluded)
Alternatively, a single compound entry may be made as follows:

Feb. 1 Cash ..........................................................................
50,375
Bond InvestmentOldtown Corp......................
Gain on Sale of Bond Investment......................
Interest Revenue.................................................
Interest Receivable.............................................
47,395
1,058
422
1,500
1033.
2005
July 1 Interest Expense ($200,000 0.09 6/12)...............
Cash.....................................................................
9,000
9,000
200*
Discount on Bonds Payable ..............................
*$184,000 0.10 6/12 = $9,200; $9,200 $9,000 = $200
Loss on Early Retirement of Bonds........................
21,800*
Bonds Payable..........................................................
200,000
Discount on Bonds Payable ($16,000 $200). .
Cash.....................................................................
*$206,000 ($200,000 $15,800) = $21,800
200
15,800
206,000
1034.
2005
Mar. 1 Interest Expense ($100,000 0.09 2/12)..............
Interest Payable...................................................
Interest Expense.................................................
1,500
1,500
50*
50
*$400,000 1.03 = $412,000;

$412,000 400,000 = $12,000 premium;
$12,000 10 = $1,200 amortization per year
$1,200 1/4 2/12 = $50 amortization on retired bonds for 2 months
Bonds Payable..........................................................
Interest Payable........................................................
Cash.....................................................................
Gain on Early Retirement of Bonds...................
*$10,800 1/4 = $2,700; $2,700 $50 = $2,650
$98,000 + $1,500 = $99,500
$100,000 + $2,650 $98,000 = $4,650
100,000
1,500
2,650*
99,500
4,650
208
Chapter 10
1035.
1. Bonds Payable....................................................
300,000
Loss on Early Retirement of Debt.....................
16,000
Cash.................................................................
306,000
Discount on Bonds Payable...........................
10,000
To record the retirement of old debt.
Cash.....................................................................
300,000
Bonds Payable................................................
300,000
To record the issue of new debt.
2. The call premium is $300,000 0.02 = $6,000
The semiannual interest savings is (0.06 0.05) $300,000 = $3,000
$6,000 $3,000 = 2 semiannual periods (1 year) before the call
premium is offset by the interest reduction.
1036.
2004
1. July 1 Cash.....................................................................
Bonds Payable................................................
To record sale of bonds at 101 plus
accrued interest.
*Accrued interest from May 1 to July 1:
$1,000,000 0.12 2/12 = $20,000
2004
2. July 1 Cash.....................................................................
Discount on Bonds Payable...............................
Bonds Payable................................................
Paid-In Capital Arising from Bond
Conversion Feature.....................................
To record sale of bonds and allocation
of sales price.
*Total to be received with conversion feature..
Less: Estimated bond price in absence of
conversion feature..........................................
Amount identified with conversion feature.....
1,030,000
1,000,000
10,000
20,000*
1,030,000
20,000
1,000,000
30,000*
20,000
$1,010,000
$
980,000
30,000
1037.
2005
Aug. 1
Interest Payable.......................................................
Cash.....................................................................
Payment of accrued interest on
conversion.
917*
Bonds Payable.........................................................
Common Stock (500 shares)..............................
Paid-In Capital in Excess of Par.........................
Conversion of $100,000 of bonds.
100,000
31 Interest Expense......................................................
Monthly accrual of interest.
8,321
*$100,000 0.11 1/12 = $917

Total discount..........................................................
Amount amortized ($9,500 13/120)......................
Remaining discount................................................
10% converted.........................................................
$9,500 1/120 0.9 = $71 (rounded)
$900,000 0.11 1/12 = $8,250
1038.
917*
Buck Machine Company Books:

Notes Payable...........................................................
Cost of Goods Sold...................................................
Inventory..............................................................
Sales.....................................................................
Gain on Restructuring of Debt...........................
847
500
98,653
71
8,250
$ 9,500
(1,029)
$ 8,471
$ 847
150,000
90,000
90,000
140,000
10,000
1039.
Southwest Enterprises Books:
Notes Payable........................................................... 4,000,000
Preferred Stock$10 Par...................................
Paid-In Capital in Excess of ParPreferred.....
Common Stock$1 Par.....................................
Paid-In Capital in Excess of ParCommon.....
Gain on Restructuring of Debt...........................
200,000
1,200,000
250,000
1,750,000
600,000
210
1040.
Chapter 10
(a) Maturity value of bonds............................................

Interest ($10,000,000 0.05 5 years)....................
Total payments to be made...................................
$10,000,000
2,500,000
$12,500,000
Because the total payments to be made exceed the carrying

value of $11,210,000
($10,000,000 + $210,000 premium +
$500,000
interest + $500,000 interest), no journal entry is
required.
(b) Maturity value of bonds............................................
Interest ($7,000,000 0.10 5 years)......................
$ 7,000,000
3,500,000
$10,500,000
Because the total payments after the restructuring are less than
the carrying value of $11,210,000 by $710,000, this amount must
be recognized as a gain with the following journal entry:
2005
Jan. 1
Bonds Payable....................................................
Premium on Bonds Payable...............................
Restructured Debt.........................................
Gain on Restructuring of Debt.....................
1,000,000
10,000,000
210,000
10,500,000
710,000
(c) Maturity value of bonds............................................

Interest ($8,000,000 0.06 5 years)......................
$ 8,000,000
2,400,000
$10,400,000
Because the total payments after the restructuring are less than
the carrying value of $11,210,000 by $810,000, this amount must
be recognized as a gain with the following journal entry:
2005
Jan. 1
Bonds Payable....................................................
Restructured Debt.........................................
Gain on Restructuring of Debt.....................
1,000,000
10,000,000
210,000
10,400,000
810,000
PROBLEMS
1041.
1.
a.
2.
Current ratio (Current assets/Current liabilities): $75,000/$50,000 = 1.50.

This solution assumes that the $90,000 difference between total liabilities
and the liabilities listed is assumed to be long term. If one assumes that
those liabilities are current, the current ratio would be 0.54 [$75,000/
($50,000 + $90,000).]
b. Debt-to-equity ratio (Total liabilities/Total equity): $300,000/$200,000 = 1.50
c.
Debt ratio (Total liabilities/Total assets): $300,000/$500,000 = 0.60
First, the existence of the refinancing arrangement should be supported by
some formal documentation. Second, if the refinancing occurs before the
financial statements are released, the auditor can verify that the actual
refinancing has taken place.
1042.
1.
Year
2005
2006
2007
2008
2009
Totals
Payment
Amount
$ 211,038
211,038
211,038
211,038
211,038
$1,055,190
Interest
Expense
$ 80,000
66,896
52,482
36,626
19,186 *
$ 255,190
Amount Applied to
Reduce Principal
$131,038
144,142
158,556
174,412
191,852
$ 800,000
Balance
$800,000
668,962
524,820
366,264
191,852
0
*Adjusted for rounding

2.
2005
Equipment
$ 800,000
Accumulated depreciation
(160,000)
Book value
$ 640,000
3.
2006
2007
2008
2009
$ 800,000 $ 800,000 $ 800,000 $ 800,000
(320,000)
(480,000)
(640,000)
(800,000)
$ 480,000 $ 320,000 $ 160,000 $
0
The depreciation decreases the book value of the asset in a straight-line

fashion, whereas the reduction in the principal of the liability changes each
year as the carrying value of the liability changes. The liability decreases more
in the later years than it does in the early years when more of each payment
goes toward the payment of interest.
212
Chapter 10
1043.
1.
Issuance on Bel Airs Books:
Cash...........................................................................
Discount on Bonds Payable....................................
Bonds Payable....................................................
Deferred Bond Issue Costs......................................
Cash.....................................................................
2.
885,300
114,700
1,000,000
30,000
30,000
Purchase on Mercurs Books:

Bond InvestmentBel Air Company......................
Cash.....................................................................
885,300
Bel Airs Adjusting Entries, December 31, 2005:

Interest Payable ($1,000,000 0.10 1/2 year).
53,305
Bond Issue Cost Expense ($30,000 10 years).....

Deferred Bond Issue Cost..................................
Mercurs Adjusting Entry, December 31, 2005:
Interest Receivable...................................................
Bond InvestmentBel Air Company......................
Interest Revenue.................................................
885,300
50,000
3,305 *
3,000
3,000
50,000
5,735
55,735
COMPUTATIONS:
Discount
Effective Interest
Stated Interest
Amortization
*Jan. 1June 30
$885,300 0.06 =$53,118
$50,000
$3,118
July 1Dec. 31
$888,418 0.06 = 53,305
50,000
3,305
$114,700 discount 10 years 6/12 = $5,735 straight-line amortization.

1044.
1.
Present value of bond maturity value:

Maturity value of bonds after 10 years or 20 semiannual periods.. $900,000
Effective interest rate8% per year, or 4% per semiannual period:
PVn = $900,000 (Table ll 20 4% )
= $900,000(0.4564)
= $410,760
FV = $900,000; N = 20; I = 4% PV = $410,748
Semiannual payment, 3% of $900,000.........................................
Effective interest rate8% per year, or 4% per semiannual
period:
$31,500
1044.
(Concluded)
PVn = $31,500(13.5903)
= $428,094
PMT = $31,500; N = 20; I = 4% PV = $428,095
Maximum amount investor should pay to earn 8%: $410,760 + $428,094 = $838,854
2.
Straight-Line Method:
A
Interest
Received
Interest
(3% of
Payment
Face Value)
1
2
$31,500
31,500
Effective-Interest Method:
A
Interest
Received
Interest
(3% of
Payment
Face Value)
1
2
$31,500
31,500
Discount
Amortization
($61,146 1/20)
Interest
Revenue
(A + B)
$3,057
3,057
$34,557
34,557
B
Interest
Revenue
(4% of Bond
Carrying Value)
C
Discount
Amortization
(B A)
$33,554*
33,636
$2,054
2,136
D
Bond
Carrying
Value
(D + B)
$838,854
841,911
844,968
D
Bond
Carrying
Value
(D + C)
$838,854
840,908
843,044
*0.04 $838,854 = $33,554
0.04 $840,908 = $33,636

The interest revenue recognized each period should be equal to the effectiveinterest revenue (effective-interest rate carrying value). This is accomplished
by use of the effective-interest method. It is preferred over the straight-line
method because it always values the investment at its present value.
214
Chapter 10
1045.
1. a. Amortization of PremiumStraight-Line Method:
A
B
C
Interest
Received
Premium
Interest
Interest
(3% of
Amortization Revenue
Payment Face Value) ($850 1/10)
(A B)
1
2
3
4
5
6
7
8
9
10
$700
700
700
700
700
700
700
700
700
700
$85
85
85
85
85
85
85
85
85
85
$615
615
615
615
615
615
615
615
615
615
D
Unamortized
Premium
(D B)
$850
765
680
595
510
425
340
255
170
85
0
E
Bond
Carrying
Value
(E B)
$20,850
20,765
20,680
20,595
20,510
20,425
20,340
20,255
20,170
20,085
20,000
b. Amortization of PremiumEffective-lnterest Method:

A
B
C
D
E
Interest
Interest
Bond
Received
Revenue
Premium Unamortized Carrying
Interest
(3% of
(3% of Bond Amortization Premium
Value
Payment Face Value) Carrying Value)
(A B)
(D C)
(E C)
$850
$20,850
1
$700
$626 (0.03 $20,850)
$74
776
20,776
2
700
623 (0.03 $20,776)
77
699
20,699
3
700
621 (0.03 $20,699)
79
620
20,620
4
700
619 (0.03 $20,620)
81
539
20,539
5
700
616 (0.03 $20,539)
84
455
20,455
6
700
614 (0.03 $20,455)
86
369
20,369
7
700
611 (0.03 $20,369)
89
280
20,280
8
700
608 (0.03 $20,280)
92
188
20,188
9
700
606 (0.03 $20,188)
94
94
20,094
10
700
606 ($700 $94)*
94
0
20,000
*Adjusted for rounding.
1045.
2.
(Concluded)
Allen Co. Books:
Bond InvestmentLocust Sales Company.............
Cash........................................................................
20,850
20,850
Cash............................................................................
Bond InvestmentLocust Sales Company.........
Interest Revenue....................................................
700
Cash............................................................................
Bond InvestmentLocust Sales Company.........
Interest Revenue....................................................
700
Locust Sales Co. Books:

Cash............................................................................
Bonds Payable.......................................................
Premium on Bonds Payable..................................
74
626
77
623
20,850
20,000
850
Interest Expense........................................................
Premium on Bonds Payable......................................
Cash........................................................................
626
74
Interest Expense........................................................
Premium on Bonds Payable......................................
Cash........................................................................
623
77
700
700
1046.
1.
Maturity value, Table ll, n = 20, i = 4% (0.4564 $100,000)................
$45,640

FV = $100,000; N = 20; I = 4% PV = $45,639
Interest payment, Table IV, n = 20, i = 4% 13.5903
n = 10, i = 4% 8.1109
5.4794 $5,000...........
27,397

PMT = $5,000; N = 10; I = 4% PV = $40,554
To discount this deferred annuity back to the present:
FV = $40,554; N = 10; I = 4% PV = $27,397
Market value..........................................................................................
$73,037
216
Chapter 10
1046. (Concluded)
2.
Recall that this bond defers interest payments until the sixth year. In doing the
present value calculations, allowance must be made for the nonpayment of
interest during years 1 through 5.
Interest
Payment
A
Interest Paid
(5% of
Face Value)
B
Interest
Expense
(D 0.04)
C
Amount
Amortized
(A B)
D
Bond Carrying
Value
(D + C)
$ 73,037
75,958
78,996
82,156
85,442
88,860
92,414
96,111
99,955
103,953
108,111
107,435
106,732
106,001
105,241
104,451
103,629
102,774
101,885
100,960
100,000
1
$
0
$2,921
$2,921
2
0
3,038
3,038
3
0
3,160
3,160
4
0
3,286
3,286
5
0
3,418
3,418
6
0
3,554
3,554
7
0
3,697
3,697
8
0
3,844
3,844
9
0
3,998
3,998
10
0
4,158
4,158
11
5,000
4,324
(676)
12
5,000
4,297
(703)
13
5,000
4,269
(731)
14
5,000
4,240
(760)
15
5,000
4,210
(790)
16
5,000
4,178
(822)
17
5,000
4,145
(855)
18
5,000
4,111
(889)
19
5,000
4,075
(925)
20
5,000
4,040*
(960)
*Rounded.
Note that with this deferred interest bond, the carrying value increased above
the face value. When interest payments were made, the amortization causes
the carrying value to be reduced to the face value.
1047.
1.
Table ll, n = 20, 1 = 0.04 (0.4564 $100,000).......................................
$ 45,640

FV = $100,000; N = 20; I = 4% PV = $45,639
Table IV, n = 20, i = 0.04 (13.5903 $5,000).........................................
67,952

PMT = $5,000; N = 20; I = 4% PV = $67,952
Market value (present value) of bond.................................................
2005
Jan. 1 Cash.................................................................................
113,592
Bond Payable............................................................
2.
a. Cash paid for interest = $100,000 0.10 = $10,000
b. Premium amortized = $13,592 10 years = $1,359
c. Interest expense = $10,000 $1,359 = $8,641
3.
a. Direct Method:
Cash flows from operating activities:
Cash receipts from customers..............................................
Cash payments for:
Inventory...................................................
$172,000
Interest expense.......................................
10,000
Other expenses........................................
82,000
Net cash provided by operating activities...
$113,592
100,000
13,592
$293,000*
264,000
$ 29,000
*$300,000 + $48,000 $55,000 = $293,000
$180,000 + $87,000 $93,000 + $58,000 $60,000 = $172,000

b. Indirect Method:
Cash flows from operating activities:
Net income...............................................................................
Adjustments:
Depreciation......................................................................
Amortization of bond premium........................................
Increase in accounts receivable......................................
Decrease in inventory.......................................................
Increase in accounts payable .........................................
Net cash provided by operating activities............................
*$120,000 $8,641 $14,500 $82,000 = $14,859
$14,859*
14,500
(1,359)
(7,000)
6,000
2,000
$29,000
218
Chapter 10
1047. (Concluded)
The following table can be used in answering 3, parts (a) and (b):
Sales
Cost of sales
Depreciation expense
Interest expense
Other expenses
Net income
Income Statement
$300,000
(180,000)
(14,500)
(8,641)
(82,000)
$ 14,859
Adjustments
7,000
+ 6,000
+ 2,000
Statement of
Cash Flows
$ 293,000
(172,000)
0
(10,000)
(82,000 )
$ 29,000
+14,500
1,359
No adjustment
$14,141
1048.
1.
2.
3.
4.
1995
July 1 Cash.....................................................................
Bonds Payable................................................
Interest Payable ($8,000,000 0.07 3/12)
1995
Oct. 1 Interest Payable...................................................
Cash.................................................................
1995
Dec. 31 Interest Expense.................................................
($426,600 6/237).......................................
Interest Payable ($8,000,000 0.07 3/12)...
7,713,400
426,600
8,000,000
140,000
140,000
140,000
280,000
150,800
2005
Apr. 1 Bonds Payable.......................................................... 1,000,000
Common Stock (25,000 shares, $1 par)..............
Paid-ln Capital in Excess of Par..........................
*Unamortized bond discount applicable to converted bonds:
April 1, 2005April 1, 2015 = 120 months
120/237 1/8 $426,600 = $27,000
10,800
140,000
27,000*
25,000
948,000
1048. (Concluded)
5.
2005
July 1 Bonds Payable..........................................................
Loss on Bond Reacquisition....................................
Cash (500 bonds $1,250)...................................
500,000
138,163*
13,163
625,000
*Loss on bond reacquisition:

Amount paid on reacquisition (500 $1,250)........ $625,000
Less: Carrying value of bonds
($500,000 $13,163).............................................. 486,837
$138,163
Unamortized bond discount applicable to reacquired bonds:

July 1, 2005April 1, 2015 = 117 months
$426,600 117/237 1/16 = $13,163 (rounded)
1049.
1.
1997
Oct. 1 Cash........................................................................... 2,941,140*
Discount on Bonds Payable.................................... 126,360
Bonds Payable......................................................
3,000,000
Interest Payable....................................................
67,500
*Bond proceeds........................................................ $2,873,640
Accrued interest: $3,000,000 0.09 3/12............
67,500
$2,941,140
2.
1997
Dec. 31 Interest Expense.......................................................
Interest Payable ($3,000,000 0.09 1/12).........
23,580
*Monthly accrual entry. Amortization of bond discount:

Life of bond issue: 9 years or 117 months
Amortization per month: $126,360 117 = $1,080
22,500
1,080*
220
Chapter 10
1049. (Continued)
3.
2003
July 1 Interest Payable ($3,000,000 0.09 6/12).............
Cash.......................................................................
135,000
135,000
Bonds Payable.......................................................... 1,000,000

17,280*
Common Stock, Par $1 (5,000 shares)...............
5,000
Paid-ln Capital in Excess of Par..........................
977,720
Conversion of bonds to stock.
*Remaining life of bonds: 48 months
$1,000,000 $3,000,000 $1,080 48 = $17,280
Number of shares of common stock issued in exchange for bonds:

$1,000,000 $1,000 5 = 5,000 shares
Carrying value of bonds assigned to shares:
$1,000,000 $17,280............................................................... $982,720
Less: Common stock at par: $1 5,000...............................
5,000
Paid-in capital in excess of par............................................. $977,720
4.
2004
Dec. 31 Interest Expense.......................................................
Interest Payable ($2,000,000 0.09 1/12).........
*Amortization of bond discount for December:
$2,000,000 $3,000,000 $1,080 = $720
15,720
15,000
720*
Bonds Payable..........................................................
500,000
Interest Payable........................................................
22,500
Loss on Bond Reacquisition....................................
1,650
Cash.......................................................................
518,750*
5,400
Reacquisition of bonds at 99%.
*Amount paid on bond retirement:
Bonds: $500,000 0.9925...................................................... $496,250
Accrued interest:
$500,000 0.09 6/12.............................................................
22,500
Cash paid.................................................................................... $518,750
Remaining life of bonds: 30 months

$500,000 $3,000,000 $1,080 30 = $5,400
Loss on bond reacquisition:

Cash paid for bonds: $500,000 0.9925............................... $496,250
Carrying value of bonds: $500,000 $5,400........................ 494,600
$ 1,650
1049. (Concluded)
5.
2005
July 1 Interest Payable ($1,500,000 0.09 6/12).............
Cash.......................................................................
67,500
67,500
Cash ($4,000,000 0.97)........................................... 3,880,000

Discount on Bonds Payable.................................... 120,000
Bonds Payable......................................................
4,000,000
Bonds Payable.......................................................... 1,500,000
Loss on Bond Retirement........................................
12,960*
Cash.......................................................................
1,500,000
12,960
*Loss on bond retirement:
Cash paid for bonds.......................................
Carrying value of bonds: par value...............
Less bond discount:
$1,500,000 $3,000,000 $1,080 24
(remaining monthslife of issue).................
Loss..................................................................
$1,500,000
$1,500,000
12,960
1,487,040
$ 12,960
222
Chapter 10
1050.
Sunderland Inc.
Income Before Income Taxes From Bond Investment
For Years Ended December 31, 2004, and 2005
2004
Interest income before amortization..................................
$18,6671
Amortization of bond discount...........................................
2,6173
Gain on sale of bonds..........................................................
Income before income taxes...............................................
$21,284
2005
$ 26,6662
3,9963
8,0074
$ 38,669
(Note: Sunderland is accounting for these bonds as a held-to-maturity investment.

See Chapter 14 for more details.)
COMPUTATIONS:
1
Interest income before amortization for 2004:

Face value of bonds (400 $1,000)................................
Interest rate......................................................................
Interest for year................................................................
$400,000
8%
$ 32,000
Interest received December 1, 2004 ($32,000 6/12).. .

Interest accrued at December 31, 2004 ($32,000 1/12)
Interest income before amortization for 2004...............
2
$ 16,000
2,667
$ 18,667
Interest income before amortization for 2005:

Interest accrued at December 31, 2004, reversed........
Interest received June 1, 2005 (6 months)....................
Accrued interest paid by buyer (June 1 November 1
5/12 $32,000)...............................................................
Interest income before amortization for 2005...............
Amortization of bond discounteffective-interest
method for 2004 and 2005:
Face value of bonds (400 $1,000)......................................
Purchase price of bonds.......................................................
Bond discount.......................................................................
Amortization of bond discount for 2004:
6 months ended December 1, 2004 ($364,547 5% =
$18,227 effective interest; $18,227 $16,000 cash
interest) .............................................................................. $
Month of December, 2004 ($364,547 + $2,227 =
$366,774; $366,774 0.05 = $18,339 effective interest;
$18,339 $16,000 cash interest = $2,339; $2,339 1/6)..
Balance of unamortized bond discount December 31, 2004
Amortization of bond discount for 2005:
5 months ended June 1, 2005 ($2,339 $390).................... $
5 months ended November 1, 2005 ($371,608 + $2,580 =
$369,113; $369,113 0.05 = $18,456 effective interest;
$18,456 $16,000 cash interest = $2,456; $2,456 5/6)..
Balance of unamortized bond discount November 1, 2005. .
1050.
(Concluded)
$ (2,667)
16,000
13,333
$ 26,666
$400,000
364,547
$ 35,453
2,227
390
2,617
$ 32,836
1,949
2,047
3,996
$ 28,840
Gain on sale of bonds for 2005:

Selling price of bonds:
Selling price of bonds, including accrued interest
paid by buyer............................................................... $392,500
Accrued interest paid by buyer (See note 2)............... (13,333)
Selling price of bonds...............................................
Carrying value of bonds:
Purchase price of bonds................................................ $364,547
Amortization of bond discount for 2004 (See note 3)..
2,617
Amortization of bond discount for 2005 (See note 3)..
3,996
Carrying value of bonds at date of sale..................
Gain on sale of bonds..........................................................
$379,167
371,160
8,007
1051.
2002
May
1 Bond InvestmentExtel Corp.......................................

Interest Receivable.........................................................
Cash............................................................................
*Cost to acquire bonds: $40,000 0.97........................
Accrued interest, March 1May 1:
$40,000 0.09 2/12..................................................
38,800
600
39,400*
$38,800
600
$39,400
Sept. 1 Bond InvestmentExtel Corp.......................................

120*
Cash.................................................................................
1,800
Interest Revenue........................................................
1,320
Interest Receivable....................................................
600
*Amortization: Discount on bonds, $40,000 $38,800 = $1,200
Life of bonds for investor, May 1, 2002 to September 1, 2005 = 40 months
Amortization: May 1 to September 1 = 4 months; 4/40 $1,200 = $120
Dec. 31 Interest Receivable.........................................................
Interest Revenue ($40,000 0.09 4/12)..................
1,200
Bond InvestmentExtel Corp.......................................

Interest Revenue ($30 amortization per month 4
months)....................................................................
120
1,200
120
(Note: To simplify this problem, it is assumed that Desert is ignoring year-to-year

market value changes in accounting for this bond investment. As discussed in
Chapter 14, this is the accounting procedure used when an investment is classified
as held to maturity.)
224
1051.
2003
Mar.
May
Chapter 10
(Continued)
Cash.................................................................................
*$30 amortization per month 2 months
60*
1,800
660
1,200

*Amortization of discount on $12,000 bonds sold:
Mar. 1May 1: 2/40 $12,000 $40,000 $1,200 = $18
Cash.................................................................................
Bond InvestmentExtel Corp...................................
Gain on Sale of Bonds...............................................
*Sold $12,000 face value bonds at 103.........................
Original cost, $12,000 0.97........................................
Amortization, 2002, $12,000 $40,000 $240.... $72
Amortization, 2003, $12,000 $40,000 $60 =
$18 + $18............................................................. 36
Carrying value of bonds sold.......................................
Gain on sale of bonds...................................................
18*
18
12,540
11,748
612*
180
$12,360
$11,640
108
11,748
$ 612
Accrued interest, Mar. 1May 1: $12,000 0.09 2/12 = $180
Sept. 1 Bond InvestmentExtel Corp.......................................

126*
Cash.................................................................................
1,260
*Amortization of discount on bonds ($28,000 face value) for 2003:
6/40 $28,000 $40,000 $1,200 = $126, or $21 per month.
2003
Dec. 31 Interest Receivable.........................................................
840
Interest Revenue ($28,000 0.09 4/12)..................
Bond InvestmentExtel Corp.......................................
84
Interest Revenue ($21 per month 4 months)........
2004
Mar. 1 Bond InvestmentExtel Corp.......................................
42
Cash.................................................................................
1,260
July

*Amortization of discount on $16,000 bonds exchanged
(March 1July 1):
4/40 $16,000 $40,000 $1,200 = $48
1051.
(Concluded)
1,386
840
84
462
840
48*
48
July
1 Cash...................................................................................
Investment in Extel Corp. Common Stock......................
Bond InvestmentExtel Corp.....................................
Gain on Exchange of Bonds........................................
Interest Revenue...........................................................
480
18,000
15,832*
2,168*
480
*Received 2,250 shares valued at $8...............................

Carrying value of bonds exchanged:
Original cost: $16,000 0.97........................................ $15,520
Amortization, 2002: $16,000 $40,000 $240. . $ 96
Amortization, 2003: $16,000 $28,000 $252. . 144
Amortization for 2004 (1/2 $144).....................
72
312
Carrying value of bonds exchanged...........................
Gain on exchange............................................................
Interest, $16,000 for 4 months (March 1July 1):

$16,000 0.09 4/12 = $480
Sept. 1 Bond InvestmentExtel Corp..........................................
Cash...................................................................................
*Amortization of discount on bonds, $12,000 for 2004:
6/40 $12,000 $40,000 $1,200 = $54, or $9 per month.
54*
540
Dec. 31 Interest Receivable...........................................................

Interest Revenue ($12,000 0.09 4/12).....................
360
Bond InvestmentExtel Corp..........................................

Interest Revenue ($9 per month 4 months).............
36
2005
Mar.
1 Bond InvestmentExtel Corp..........................................

Cash...................................................................................
Interest Receivable.......................................................
*Amortization of discount on bonds of $12,000:
($9 per month 2 months)
Sept. 1 Bond InvestmentExtel Corp..........................................

Interest Revenue ($9 per month 6 months).............
Fitzgerald Inc. Books:
15,832
$ 2,168
594
360
36
18*
540
198
360
54
Cash................................................................................... 12,540*
Bond InvestmentExtel Corp.....................................
*Proceeds on bond redemption:
Face value of bonds...................................................... $12,000
Interest: $12,000 0.09 6/12......................................
540
Total cash received....................................................... $12,540
1052.
$18,000
54
12,000
540
226
Chapter 10
2001
Apr. 1 Cash..................................................................................
Discount on Notes Payable.............................................
Notes Payable..............................................................
Sale of notes to underwriter.
Oct.
1 Interest Expense..............................................................
Cash ($750,000 0.11 6/12)......................................
Discount on Notes Payable ($30,000 8 6/12).......
Semiannual interest payment and amortization of
discount.
720,000
30,000
750,000
43,125
41,250
1,875
Dec. 31 Interest Expense [($750,000 0.11) 3/12]...................

Interest Payable...........................................................
Accrual of 3 months interest.
20,625
Interest Expense [($30,000 8) 3/12] (rounded).........

Discount on Notes Payable........................................
Amortization of discount: 3 months.
938
2005
Apr. 1 Interest Expense..............................................................
Interest Payable...............................................................
Cash..............................................................................
Semiannual interest payment.
20,625
938
20,625
20,625
41,250
Interest Expense [($30,000 8) 3/12] (rounded).........

Discount on Notes Payable........................................
Discount amortization for 3 months.
938
Notes Payable..................................................................
Loss on Redemption of Notes Payable.........................
Discount on Notes Payable ($30,000 4/8)...............
Cash ($750,000 1.04)................................................
Redemption of notes at 104.
750,000
45,000
938
15,000
780,000
L. Baum Books:
2001
July 1 Investment in Fitzgerald Inc. Notes................................
Interest Receivable..........................................................
Cash..............................................................................
Purchase of $750,000 of 11% notes for $757,500
($750,000 1.01) plus accrued interest of $20,625
($750,000 0.11 3/12).
757,500
20,625
778,125
1052.
Oct.
(Continued)
1 Cash..................................................................................
41,250
Investment in Fitzgerald Inc. Notes...........................
242*
Interest Revenue..........................................................
20,383
Interest Receivable......................................................
20,625
Semiannual interest receipt.
*Total amortization period93 months. 3/93 $7,500 = $242 (rounded)
Dec. 31 Interest Revenue..............................................................

Amortization of premium on notes for 3 months.
242
20,625
242
20,625
(Note: To simplify this problem, it is assumed that the investors are ignoring year-toyear market value changes in accounting for this note investment. As discussed in
2004
Apr. 1 Cash..................................................................................
Investment in Fitzgerald Inc. Notes (3/93 $7,500). .
41,250
June 1 Interest Receivable ($750,000 0.11 2/12)..................

13,750
Interest Revenue (2/93 $7,500)....................................

Amortization of premium2 months.
161
Cash..................................................................................
Loss on Sale of Notes.....................................................
Sale of notes.
20,625
20,383
242
13,750
161
732,750*
35,677
754,677
13,750
*$750,000 0.96 = $720,000 + $13,750 interest $1,000 brokerage costs =

$732,750
35 months elapsed since purchase. 93 35 = 58 months remaining.

58/93 $7,500 = $4,677 unamortized premium.
Total investment: $750,000 + $4,677 = $754,677
228
Chapter 10
1052.
(Concluded)
J. Gott Books:
2004
June 1 Investment in Fitzgerald Inc. Notes................................
Cash..............................................................................
Purchase of $750,000 of 11% notes for $721,500
[($750,000 0.96) + $1,500] plus accrued interest
of $13,750 ($750,000 0.11 2/12).
*($750,000 0.96) + $1,500 = $721,500
Oct. 1 Cash..................................................................................
1 Investment in Fitzgerald Inc. Notes................................
*$750,000 $721,500 = $28,500 discount;
4/58 $28,500 = $1,966 (rounded)
2004
Dec. 31 Interest Receivable..........................................................
*3/58 $28,500 = $1,474 (rounded)
721,500*
13,750
735,250
41,250
27,500
13,750
1,966*
1,966
20,625
20,625
1,474*
1,474
2005
Apr. 1 Cash..................................................................................
41,250
Receipt of interest from Fitzgerald prior to redemption.
*3/58 $28,500 = $1,474 (rounded)
1 Cash ($750,000 1.04).....................................................
Investment in Fitzgerald, Inc. Notes..........................
Gain on Redemption of Notes....................................
Redemption of notes at 104.
*Unamortized discount (48 months early):
48/58 $28,500 = $23,586;
$750,000 $23,586 = $726,414
20,625
20,625
1,474*
1,474
780,000
726,414*
53,586
1053.
1.
Jan. 21 Bond InvestmentBig Oil........................................

Interest Receivable ($206,550 $204,000).............
Cash.......................................................................
204,000
2,550
206,550
Mar. 1 Interest Revenue.......................................................

38
Bond InvestmentBig Oil...................................
*Premium amortization for 1 month on bonds of $100,000 sold:
(Life of bonds, 52 months to nearest month).
1/52 $100,000 $200,000 $4,000 = $38
Cash...........................................................................
106,000
Gain on Sale of Big Oil 9% Bonds.......................
Interest Revenue ($100,000 0.09 3/12)..........
*Proceeds from sale of bonds: $106,000 $2,250 $103,750
Carrying value of bonds of $100,000 sold:
[($100,000 $200,000) $204,000] $38............ 101,962
Gain on sale............................................................. $ 1,788
38*
101,962
1,788*
2,250
(Note: The $2,250 in interest received could also be allocated between Interest
Revenue and Interest Receivable. In this solution, all of the Interest Receivable is
eliminated on June 1.)
June 1 Cash ($100,000 0.09 6/12)...................................
Interest Receivable...............................................
*Premium amortization on bonds of $100,000 for
4 months (February 1June 1):
4/52 $100,000 $200,000 $4,000 = $154
Nov. 1 Interest Revenue.......................................................
*Premium amortization on bonds called:
5/52 $40,000 $200,000 $4,000 = $77 (rounded)
Cash...........................................................................
Loss on Redemption of Big Oil 9% Bonds.............
Interest Revenue ($40,000 0.09 5/12)............
*Bond redemption:
Carrying value of bonds redeemed:
$40,800 $138 ($800 9/52)...................................
Redemption price: $40,000 101%........................
Loss on redemption................................................
4,500
154*
1,796
2,550
77
77*
41,900
262*
40,662
1,500
$40,662
40,400
$ 262
230
Chapter 10
1053.
(Concluded)
Dec. 1 Cash ($60,000 0.09 6/12).....................................

*6/52 $60,000 $200,000 $4,000 = $138 (rounded)
Dec. 31 Interest Receivable ($60,000 0.09 1/12).............
*1/52 $60,000 $200,000 $4,000 = $23 (rounded)
2,700
138*
2,562
450
23*
427
(Note: To simplify this problem, it is assumed that Carmichael is ignoring year-toyear market value changes in accounting for this bond investment. As discussed in
2.
Dec. 31 Bond InvestmentBig Oil........................................

Interest Receivable...................................................
Loss on Redemption of Big Oil 9% Bonds.............
Gain on Sale of Big Oil 9% Bonds.......................
9,496
450
262
8,420
1,788
(Note: Several entries could be made to correct the accounts, but the net effect on
the accounts is summarized by the preceding single compound entry.)
The investment account should have a balance of $60,946 [($60,000 $200,000
$204,000) ($1,200 11/52)]. The account as maintained shows a balance of $51,450,
thus requiring a debit of $9,496. Interest of $450 is accrued for 1 month. Interest
revenue and the gain accounts report credit balances as determined in part (1).
1054.
2000
Apr. 1 Cash..................................................................................
525,000*
Bonds Payable.............................................................
Premium on Bonds Payable.......................................
To record sale of bonds.
*Selling price of bonds: $500,000 @ 102....................... $510,000
Accrued interest: $500,000 0.12 3/12......................
15,000
Proceeds from sale of bonds........................................ $525,000
July 1 Premium on Bonds Payable...........................................
256*
15,000
Interest Expense..............................................................
14,744
Cash ($500,000 0.12 6/12)......................................
To record payment of semiannual interest.
April 1, 2000 to January 1, 2010 = 117 months
$10,000 3/117 = $256 amortization for 3 months (rounded)
1054.
(Continued)
500,000
10,000
15,000
30,000
Dec. 31 Interest Expense..............................................................

To record accrual of semiannual interest.
30,000
Premium on Bonds Payable ($10,000 6/117)..............

Interest Expense..........................................................
To record premium amortization.
513
2005
Jan. 1 Interest Payable...............................................................
Cash..............................................................................
To record payment of semiannual interest.
30,000
513
30,000
Apr. 1 Premium on Bonds Payable...........................................

*Premium amortization for 3 months on reacquired bonds:
$10,000 1/2 3/117 = $128 (rounded)
30,000
128*
128
2005
Apr. 1 Bonds Payable.................................................................
250,000
Premium on Bonds Payable...........................................
2,436
7,500
Gain on Bond Reacquisition.......................................
4,936*
Cash..............................................................................
255,000
To record reacquisition of bonds.
*Gain on bond reacquisition:
Par value of reacquired bonds................................... $250,000
Unamortized premium: April 1, 2005
January 1, 2010 = 57 months
$10,000 1/2 57/117 (rounded)................................
2,436
Carrying value of bonds at reacquisition date..........
$252,436
Cost to reacquire bonds ($250,000 @ 99).................
247,500
$ 4,936
Cash paid in bond reacquisition:

Cost to reacquire bonds.............................................
$247,500
Interest for 3 months ($250,000 0.12 3/12)...........
7,500
$255,000
232
Chapter 10
1054.
(Concluded)
June 30 Premium on Bonds Payable ($10,000 1/2 6/117).....

256
256
Bonds Payable.................................................................
250,000
Premium on Bonds Payable...........................................
2,308
15,000
Gain on Bond Reacquisition.......................................
9,808*
Cash..............................................................................
257,500
To record reacquisition of bonds.
*Gain on bond reacquisition:
Par value of reacquired bonds...................................... $250,000
Unamortized premium: July 1, 2005
January 1, 2010 = 54 months
$10,000 1/2 54/117.....................................................
2,308
Carrying value of bonds at reacquired date................................... $252,308
Cost to reacquire bonds ($250,000 @ 97)...................................... 242,500
$ 9,808
Cash paid in bond reacquisition:

Cost to reacquire bonds.................................................................. $242,500
Interest for 6 months ($250,000 0.12 6/12)................................
15,000
$257,500
30 Cash..................................................................................
Bonds Payable.............................................................
To record sale of 9% bonds.
400,000
400,000
1055.
1.
Maturity value, Table ll, n = 20, I = 4% (0.4564 $100,000,000)...
$45,640,000

FV = $100,000,000; N = 20; I = 4% PV = $45,638,695
Interest payments, Table IV,
n = 20, I = 4%. .
n = 10, I = 4%. .
13.5903
8.1109
5.4794 $5,000,000........
27,397,000

PMT = $5,000,000; N = 10; I = 4% PV = $40,554,479
Then, to discount the deferred annuity back to the present:
FV = $40,554,479; N = 10; I = 4% PV = $27,397,153
Market value...............................................................................
1055.
(Concluded)
$73,037,000
Because interest payments do not begin until Year 6, students must be careful
to include only the present value of those interest payments actually being
made.
2.
Cash.................................................................................
Discount on Bonds Payable..........................................
Bonds Payable..........................................................
73,037,000
26,963,000
Cash.................................................................................
Loss on Sale of Assets..................................................
Net Assets.................................................................
70,000,000
15,000,000
100,000,000
85,000,000
Maturity value, Table ll, n = 14, I = 7% (0.3878 $100,000,000)...
3.
$38,780,000

FV = $100,000,000; N = 14; I = 7% PV = $38,781,724
Interest payments, Table IV,
n = 14, i = 7%.....
n = 4, i = 7%.....
8.7455
3.3872
5.3583 $5,000,000........
26,791,500

PMT = $5,000,000; N = 10; I = 7% PV = $35,117,908
Then, to discount the deferred annuity back to the present:
FV = $35,117,908; N = 4; I = 7% PV = $26,791,284
Market value...............................................................................
4.
$65,571,500
Bonds Payable................................................................ 100,000,000

Discount on Bonds Payable....................................
4,000,000
Cash...........................................................................
65,571,500
Gain on Bond Reacquisition....................................
30,428,500
5.
Mr. Dealer was able to buy his bonds back at a gain without ever having to make
an interest payment because of the movement of interest rates. An increase in
interest rates reduced the present value of the interest payments. In this case,
rates increased to the point that the bonds were worth less than they originally
were issued for.
6.
Under current GAAP, Mr. Dealer would have to wait until the bonds were retired
to recognize the gain arising from interest rate increases. Because the FASB has
moved toward a market value basis for investment securities, industries such as
finance and insurance have argued for allowing current values on liabilities
related to their investment assets. FASB has agreed to study this issue more
fully. Consistency would seem to argue for this similar treatment between the
valuation of investment assets and related liabilities.
1056.
2005
Aug. 1 Bonds Payable.................................................................
Common Stock ($1 par)..............................................
100,000
700
234
Chapter 10
Discount on Bonds Payable.......................................

Paid-ln Capital in Excess of Par.................................
Conversion of bonds to stock.
*Amount to be amortized over 120 months at $100.00 per month
Less: Amortization for 13 months to July 31, 2005.......................
Unamortized balance on July 31, 2005...........................................
Write-off of unamortized bond discount:
1,070*
98,230
$12,000
1,300
$10,700
$100,000
$10,700 = $1,070
$1000
,
,000
Paid-ln Capital in Excess of Par: $100,000 ($700 + $1,070) = $98,230
Cash..............................................................................
To record payment of interest on bonds converted:
$100,000 at 9% for 1 month.
750
750
31 Interest Expense..............................................................
90*
90
Amortization of bond discount for August.
*Unamortized balance, July 31, 2005............................................... $10,700
Less: Write-off of bond discount on August 1, 2005.....................
1,070
Unamortized balance, August 1, 2005............................................
$ 9,630
Amortization of bond discount: $9,630 107 remaining months = $90
Interest Expense ($900,000 0.09 1/12)......................
6,750
To record accrued interest for August on $900,000 at 9%.
Amortization of bond discount for December.
90
To record accrued interest for December.
6,750
Retained Earnings...........................................................
To close interest expense account.
87,400*
*Total amortization in 2005:

7 months $100..............................................................
5 months $90................................................................
Total amortization charged to interest expense..........
1056.
(Concluded)
Interest on bonds:
0.09 $1,000,000 = $90,000 1/12 = $7,500 per month
0.09 $900,000 = $81,000 1/12 = $6,750 per month
Total interest paid in 2005:
6,750
90
6,750
87,400
$ 700
450
$1,150
7 months $7,500........................................................
5 months $6,750........................................................
$52,500
33,750
$86,250
Total debits to interest expense:

Amortization of discount...............................................................
Interest paid....................................................................................
$ 1,150
86,250
$87,400
1057.
1.
Brewster Company (lssuer):

2004
Jan. 1 Cash........................................................................
Bonds Payable...................................................
Premium on Bonds Payable.............................
2,155,534*
2,000,000
155,534
Investor:
2004
Jan. 1 Bond InvestmentBrewster Company............... 2,155,534*
Cash....................................................................
2,155,534
COMPUTATIONS (for 11% bonds):
*PV = R(PVF)
R = $2,000,000
PVF = 0.6499 (Table II, 5 years, 9% interest)
$2,000,000 0.6499 .................................................................................. $1,299,800
FV = $2,000,000; N = 5; I = 9% PV = $1,299,863
PV = R(PVAF)
R = $220,000 ($2,000,000 11%)
PVAF = 3.8897 (Table IV, 5 years, 9% interest)
$220,000 3.8897 .....................................................................................
855,734

PMT = $220,000; N = 5; I = 9% PV = $855,723
$2,155,534
236
Chapter 10
1057. (Continued)
Brewster Company (Issuer):
2004
July 1 Cash........................................................................
Discount on Bonds Payable..................................
Bonds Payable...................................................
4,580,950
419,050
5,000,000
Investor:
2004
July 1 Bond InvestmentBrewster Company...............
Cash....................................................................
4,580,950
4,580,950
COMPUTATIONS (for 10% bonds):

PV = R(PVF)
R = $5,000,000
PVF = 0.4970 (Table II, 12 periods, 6% interest)
$5,000,000 0.4970...............................................................................
$2,485,000

FV = $5,000,000; N = 12; I = 6% PV = $2,484,847
PV = R(PVAF)
R = $250,000 ($5,000,000 5%)
PVAF = 8.3838 (Table IV, 12 periods, 6% interest)
$250,000 8.3838 .................................................................................
2,095,950

PMT = $250,000; N = 12; I = 6% PV = $2,095,961
$4,580,950
2.
a.
Bond ConversionBrewster Company:
2005
July 1 Bonds Payable....................................................
Loss on Conversion of Bonds..........................
Common Stock, $1 par...................................
Paid-ln Capital in Excess of Par....................
1,500,0001
185,3532
Bond ConversionInvestor:
2005
July 1 Investment in Brewster Co. Common Stock. . .
Investment in Brewster Company Bonds.....
Gain on Conversion of Bonds.......................
1,575,0006
110,3533
15,0004
1,560,0005
1,389,6477
185,3532
1057.
(Continued)
COMPUTATIONS:
1
$5,000,000 1,500/5,000 = $1,500,000
2
FMV of common stock......................................................
Carrying value of bonds...................................................
Loss/gain on conversion..................................................
$1,575,000
1,389,647 (See note 7
below)
$ 185,353
$419,050 1,500/5,000 = $125,715 $7,457 $7,905 = $110,353 (See note 7

below)
4
15,000 shares $1 = $15,000
5
15,000 shares ($105 $1) = $1,560,000
6
15,000 shares $105 = $1,575,000
7
Present value of bonds 7/1/04..........................................
$1,374,285*
Interest expense/revenue at 12% 6/12.......................... $ 82,457
Interest payment/receipt at 10% 6/12...........................
(75,000)
Discount amortization for period.....................................
7,457
$1,381,742
Interest expense/revenue at 12% 6/12.......................... $ 82,905
Interest payment/receipt at 10% 6/12...........................
(75,000)
Discount amortization for period.....................................
7,905
$1,389,647
3
*Conversion of 1,500/5,000 bonds = 30% $4,580,950 = $1,374,285

Early Bond RetirementBrewster Company:
2005
Dec. 31 Premium on Bonds Payable...............................
Interest Expense.............................................
Bonds Payable....................................................
Cash.................................................................
Gain on Bond Retirement...............................
Early Bond RetirementInvestor:
2005
Dec. 31 Interest Revenue.................................................
Bond InvestmentBrewster Company........
Cash.....................................................................
Loss on Bond Retirement...................................
Interest Revenue.............................................
28,3421
28,342
2,000,000
220,0001
101,1902
2,200,0003
121,1904
28,3421
28,342
2,200,0003
121,1904
2,101,1901
220,0001
238
Chapter 10
1057.
(Concluded)
COMPUTATIONS:
1
Interest payment/receipt at 11%...................................
Interest expense/revenue at 9%....................................
Premium amortization for period.....................................
Interest payment/receipt at 11%...................................
Interest expense/revenue at 9%....................................
Premium amortization for period.....................................
Present value of bonds 12/31/05......................................
$2,155,534
$ 220,000
(193,998)
26,002
$2,129,532
$ 220,000
(191,658)
28,342
$2,101,190
$($2,155,534 $2,000,000) $26,002 $28,342 = $101,190 (See note 1 above)

$1,980,000 + $220,000 = $2,200,000
4
Carrying value of bonds.................................................... $ 2,101,190
Cash paid/received on bond retirement.......................... (1,980,000)
Gain/loss on bond retirement........................................... $ 121,190
2
b.
Bond ConversionBrewster Company:
2005
July 1 Bonds Payable....................................................
Common Stock, $1 par...................................
Paid-In Capital in Excess of Par....................
Bond ConversionInvestor:
2005
July 1 Investment in Brewster Co. Common Stock....
COMPUTATION:
1
Carrying value of bonds....................................................
[See computations for note 7 (2a)]
Less: Par value of common stock exchanged................
Amount assigned to paid-in capital.................................
Early Bond RetirementBrewster Company:
Same as for (2a).
Early Bond RetirementInvestor:
Same as for (2a).
1,500,000
110,353
15,000
1,374,6471
1,389,647
1,389,647
$1,389,647
15,000
$ 1,374,647
1058.
2003
Dec. 31 Equipment........................................................................
Gain on Sale of Equipment.........................................
To write up equipment in preparation for debt
restructuring.
Notes Payable..................................................................
Accumulated DepreciationEquipment.......................
Equipment....................................................................
Notes Receivable.........................................................
Gain on Restructuring of Debt...................................
To record settlement of debt with Barboza.
2003
Dec. 31 Notes Payable..................................................................
Cash..............................................................................
To record payment to Janeiro.
2004
To record accrual of interest owed to Janeiro.
2005
Notes Payable..................................................................
Cash..............................................................................
To record payment to Janeiro.
20,000
20,000
300,000
60,000
40,000
100,000
250,000
50,000
100,000
100,000
12,000*
12,000
12,360*
12,000
400,000
424,360
*Imputed interest rate:

$424,360 PVF = $400,000 (rounded); PVF = 0.9426 from Table ll, Appendix B;
Interest Rate = 3% (n = 2)
PV = ($400,000); N = 2; FV = $424,360 I = 3.00%
Date
Payment
12/31/03
12/31/03
$100,000
12/31/04
12/31/05
424,360
Before restructuring.
Relates to Expanded Material.
3% Interest
Principal
$12,000
12,360
$100,000
412,000
Balance
$500,000
400,000
412,000
0
240
Chapter 10
1059.
1.
2.
Total payment under original terms:

Principal due in 5 years................................................. $6,000,000
Interest at 11% for 5 years ($6,000,000 0.11 5)....... 3,300,000 $9,300,000
Total payment under revised terms:
Principal due in 5 years................................................. $5,525,000
Interest at 8% for 5 years ($5,525,000 0.08 5)......... 2,210,000 7,735,000
Difference in cash payments.............................................
$1,565,000
2004
Dec. 31 Interest Expense ($6,000,000 0.11 6/12)......
330,000
660,000
Cash.................................................................
990,000
To record payment of interest.
Notes Payable...................................................... 6,000,000
Restructured Debt...........................................
6,000,000
To reclassify debt. No loss recognized because total payments
exceed carrying value of debt.
2005
June 30 Interest Expense ($6,000,000 0.06 6/12)......
Restructured Debt ($221,000 $180,000).........
Cash ($5,525,000 0.08 6/12)......................
First semiannual interest payment after
restructuring.
Dec. 31 Interest Expense.................................................
Restructured Debt ($221,000 $178,770).........
Cash.................................................................
Second semiannual interest payment
after restructuring.
*($6,000,000 $41,000) 0.06 6/12 = $178,770
180,000
41,000
221,000
178,770*
42,230
221,000
Note: The implicit interest rate of 6% can be computed as follows:

PV = $6,000,000 (carrying amount of the loan is unchanged because all interest is paid up under
the old terms)
PMT = $221,000 ($5,525,000 0.08 6/12)
FV = $5,525,000 ($6,000,000 $475,000)
N= 10 (five years remaining; semiannual interest payments)
I = ???; the solution is 2.99%.
The semiannual implicit interest rate is 2.99%, so the annual equivalent is approximately 6%.
DISCUSSION CASES
Discussion Case 1060
Both leases and pro athletes contracts involve the probable future sacrifice of economic benefit by the
owner of the team. The differences between the two events relate to certainty and measurement, which
in turn are dependent on the specific terms of the leases or contracts. It is possible that a player may not
fulfill contractual obligations due for poor performance or other reasons. Thus, a players contract might
be considered a less-than-probable liability and thereby not require disclosure. Regarding measurement,
it is generally more difficult to measure the future benefit to be provided by an individual than to measure
the benefit provided by a building. The future benefit to be provided by a leased building remains
relatively constant while the benefit from an individual player can vary a great deal.
Investors and creditors would prefer more information to less. If sports franchises are locked into longterm player contracts, investors and creditors would want that information disclosed as it would affect
their assessment of future cash flows of the organization.
Critics of the FASB for not requiring discounting of all future obligations argue that the time value of
money concept is appropriate for all long-term liabilities. These critics argue that the time value of
money is especially important in relation to deferred taxes because of the uncertainty associated with
future payment of those taxes. Why the FASB requires discounting with some long-term liabilities but not
with others is unclear. If liabilities must be retired with future dollars, then the use of discounting seems
appropriate. The FASB is currently studying this matter.
a. Reclassification of the note payable is permitted only if one of the following conditions is met: (1) the
refinancing must actually take place during the period between year-end and the date the balance
sheet is issued or (2) a definite agreement for refinancing is reached prior to issuance of the balance
sheet. It is not enough to indicate that such refinancing will probably take place.
b. Compensated absences must be accrued wherever possible, even though estimates are required.
Class discussion could include exploration of how estimates might be made when the variables
mentioned by the controller are present. It is not necessary that specific employees be identified for
the liability. Overall averages may be used to help compute an amount to be recorded.
This case allows for general discussion of the issues involved in accounting for bonds. The primary
issues are as follows:
(1) Accounting for the issuance price. The discussion here might note that issuers generally record a
discount or a premium as a contra or adjunct account to Bonds Payable, while investors generally
record bond investments at cost (with no contra or adjunct account involved). The discount or
premium involved is an adjustment of the stated rate of interest to the effective or yield rate of
interest. The reason Startup received less than $100,000 upon sale of the bonds is that investors
demanded a yield of 12% rather than the 10% stated rate. The amount of the discount can be
computed as follows:
PV of $100,000 at 6% for 9 periods [$100,000 0.5919 (Table ll, Appendix B)]....... $59,190
PV of $5,000 annuity at 6% for 9 periods [$5,000 6.8017 (Table IV, Appendix B)]
34,009
Issuance price............................................................................................................ $93,199
Discount = Face Issuance Price = $100,000 $93,199 = $6,801

FV = $100,000; N = 9; I = 6% PV = $59,190
242
Chapter 10

PMT = $5,000; N = 9; I = 6% PV = $34,008
The discount will be amortized over the life of the bonds and effectively increases the amount of
interest expense for Startup from the stated 10% to the effective rate of interest of 12%.
It should also be noted that if bonds are sold between interest dates, the issuer will require the
purchaser to pay the bond price plus accrued interest. The accrued interest will be paid back at the
first interest payment date. In this case, the bonds were sold on an interest payment date.
(2) Accounting for the applicable interest expense during the life of the bonds. Here the discussion
should contrast the straight-line method of amortizing discount or premium with the effective-interest
method. The effective-interest method is the more theoretically correct method and is generally
required by GAAP. Using the effective-interest method, the journal entries for 2004 to record the
bonds issued by Startup would be as follows:
July
1 Cash...........................................................................................
Discount on Bonds Payable.......................................................
Bonds Payable........................................................................
93,199
6,801
Dec. 31 Bond Interest Expense...............................................................

Discount on Bonds Payable....................................................
Interest Payable......................................................................
100,000
5,592*
592
5,000
*$93,199 0.12 6/12 = $5,592

(3) Accounting for the eventual retirement of the bonds. It should be noted that if the bonds are held to
maturity, any discount or premium will have been amortized totally. Only the bonds payable will need
to be removed from the books by paying the face value of the bonds in cash. If the bonds are retired
early, any unamortized discount or premium must be written off as well as the bonds payable, and
the difference between the cash paid to retire the bonds and the carrying value of the bonds must be
recorded as a gain or loss on retirement. Assuming early retirement of the Startup Company bonds
on July 1, 2006, after paying the interest due on July 1, 2006, and assuming use of straight-line
amortization, the loss on retirement would be computed as follows:
Cash paid at retirement ($100,000 1.02).............................
Carrying value of bonds at 7/1/06:
Bonds payable..................................................................
Less: Unamortized discount.............................................
Loss on retirement..................................................................
$102,000
$100,000
3,778*
$
96,222
5,778
*$6,801 54 months = $125.94/mo. amortization 30 months

left to maturity = $3,778 (rounded)
The retirement entry would be
Bonds Payable........................................................................
Loss on Early Retirement of Bonds........................................
Discount on Bonds Payable..............................................
Cash.................................................................................
100,000
5,778
3,778
102,000

There is such a high yield on disaster bonds because of the high risk involved and the difficulty in
gathering information to reduce that risk. As one large corporate bond investment manager put it, Wed
have to become experts in meteorology. Anyone who has watched the evening news for tomorrows
weather knows how difficult it is to predict the elements.

This case centers on the nature of convertible securities. Biggs, the company accountant, assumes that
the conversion is not a significant economic transaction that establishes new values. Under the historical
cost system, no entries are made for value changes unless a significant transaction occurs. Biggs
position assumes that when the convertible debentures were issued, the potential for conversion was
included in the transfer price. Thus, the proceeds could be regarded as consideration received for the
stock. Because the debenture and the conversion privilege are inseparably linked into one document, no
separation can be made between the debt and equity portions of the security at the time of issuance.
When conversion occurs, the same historical cost transfer price is used to record the conversion from
debt to equity. No gain or loss can be recorded, so the argument goes, because there is no pure debt
cost figure to compare with the current market price.
Robinsons position assumes that a significant economic transaction has occurred and that the market
value of the equity given up should govern the value used for the conversion. Because 8,000 shares of
common stock are issued in the conversion, the total market value of the stock would be $112,000
(8,000 $14), and the entry would be:
Loss on Conversion of Bonds.................................................
Bonds Payable........................................................................
Common Stock.................................................................
Paid-ln Capital in Excess of Par.......................................
14,500
100,000
2,500
8,000
104,000
This position can be defended as being in accordance with the substance of APB Opinion No. 29,
Accounting for Nonmonetary Exchanges. No reference is made in the opinion to convertible bonds;
however, the opinion does specify that market values should be used to value the majority of exchanges.
Because market values are available in this case, the equity could be reported at that value and a loss
recognized for any difference between the carrying value of the liability and the market price of the
equity.
Ashworths position is that the market value of the debentures should govern the conversion value. The
difference between the carrying value of $97.50 and the current market value of $104.00 is the loss that
should be recognized. The entry to reflect this position would be as follows:
Loss on Conversion of Bonds.................................................
Bonds Payable........................................................................
Common Stock.................................................................
Paid-ln Capital in Excess of Par.......................................
6,500
100,000
2,500
8,000
96,000
Usually, the market prices of the debt security and the equity security would be more closely correlated
than they are in this case. However, in the circumstances described, the existence of the call price of 103
tends to dampen the market value of debentures. If bondholders felt the market value of the stock was
realistic and assessed positively the long-term prospects for the stock, they would probably convert their
bonds before the company could place a call on the debentures. The existence of the call price and the
corresponding close relationship between the call price and the current market price of the debenture
reflect a more realistic value for the conversion than does the stock price.
The case discussion could focus on the difference in entries under the three positions and the theoretical
arguments presented for each. Because the standard-setting boards have not directly commented on this
area, there is much room for differences of opinion. Practice tends to favor the position of Biggs.
244
Chapter 10

1. When a firm is being considered as a takeover target, large amounts of debt on the balance sheet
tend to make the firm less attractive. Companies that require substantial cash flows to service debt
are not viewed as desirable acquisitions. Firms that buy other companies often incur debt to make
the acquisition and use the cash flows of the purchased company to service the debt. Debt may offer
the advantage of being of a limited duration. While stock ownership allows one to hold a stake in the
company into the foreseeable future, bonds will eventually be retired.
2. Deferred interest allows companies incurring debt to postpone any cash outflows associated with that
debt for a certain period of time. Thus, firms can incur debt and not be required to make interest
payments for several years. The disadvantage to deferred interest is that the proceeds from the bond
sale are less because of the reduced cash flow to investors. Interest rate resets are an attractive
feature for purchasers of bonds because they almost guarantee a high return. If the market value of
the bonds declines, the interest rate reset provision increases the interest payments associated with
the bond, thereby increasing the bonds value.
3. As mentioned in item (1), firms with large amounts of debt are not attractive as takeover targets
because of the cash flow required to service the debt. In the case of Interco, the board of directors
incurred large amounts of debt and used a portion of the debt proceeds as a special dividend to
stockholders.
1. The purpose of debt covenants is to require management to operate the company in such a way as
to reduce the risk to bondholders. The Circle K covenants, for example, place limits on the amount
of dividends that may be paid to shareholders and require a certain level of net worth. The covenants
ensure that the interests of bondholders will be considered when management decisions are made.
2. The $5 million payment sets aside funds to compensate parties to the sales and leaseback
transactions should the company be unable to complete its obligations associated with the
transaction.
3. The requirement to place $5 million in escrow will not improve the cash flow position of the firm.
However, it will provide assurance to the parties to the sales and leaseback transactions that, should
the company fail, some money is available as compensation.
Although the use of current values using market interest rates for assets has been discussed for many
years, the application of the same theory to liabilities is not well understood. If a company has an
outstanding liability and interest rates rise, the current value of the security representing the liability will
fall. That is, the fixed interest rate on the security, compared to the increased market rate will be
reflected in a lower security value. If an investor reduces the asset value to reflect this decline and
recognizes a loss, some would argue that a creditor should be able to reduce the liability to reflect what
could happen if the creditor refinanced the debt and was able to retire the debt for less than maturity
value. To the creditor, this would represent a gain. Many financial institutions claim a relationship
between their assets and liabilities that suggests this symmetry of treatment. Of course, if interest rates
fall, the value of the security would rise to reflect the favorable security values relative to the market
rates and a loss would occur. FASB Statement No. 115 (discussed in Chapter 14) addressed the issue of
allowing for liability gains to offset asset losses but rejected the extension at this time as being beyond
the scope of the statement (paragraph 56).

The ability to move large amounts of debt off the balance sheets of many large corporations is
troublesome to many financial statement users. If 50% or more of the ownership in the newly formed
corporations is retained by the parent company, a consolidation would be required and the debt would
remain on the balance sheet. However, if less than 50% of the stock is retained, consolidation is not
required. Often control is still maintained at a stock ownership of less than 50% (Coca-Cola retained 49%
of the stock of Coca-Cola Enterprises), but current GAAP does not require consolidation unless the stock
ownership is 50% or more. As noted in Chapter 14, this issue is one of several being considered by
FASB as it considers the entire area of consolidations and control. Factors other than stock ownership
should be considered when deciding whether consolidation is appropriate.
Under the provision of FASB Statement No. 140, a liability is removed from the balance sheet if and only
if either (a) the debtor pays the creditor and is relieved of its obligation for the liability or (b) the debtor is
legally released from bearing the primary obligation under the liability either judicially or by the creditor.
The key concept here is that a debtor must continue to report a liability as long as the debtor bears a
legal obligation. Because in-substance defeasance does not eliminate a debtors legal obligation to
continue to service the debt, the transaction is not accounted for as a debt extinguishment.
The discussion of this case will give instructors the opportunity to explore the impact GAAP can have on
the informational content of financial statements. The facts are based on a real case that occurred in the
early 1970s. The company was Aranco, Inc. The auditors in the case agreed with the company and
allowed it to transfer the amount carried in the bond liability account to preferred stock. They reported
this in their audit report as an exception to GAAP as specified by the APB but indicated that under the
circumstances, they felt the alternative accounting treatment was preferred.
Since this case occurred, the FASB has issued Statement No. 15, Accounting by Debtors and Creditors
for Troubled Debt Restructuring. In this statement, an equity swap, such as the one described in this
case, is to be accounted for at the fair market values of the debt or equity involved. This statement
solidifies the earlier position of the profession and would make it even more difficult to justify a departure
from GAAP. However, the reporting of a gain in the midst of poor operating conditions does result in
strange financial statements. Alternative reporting systems may be necessary to more clearly distinguish
between this type of gain and other more common operating gains and losses. Without this special
treatment, readers could misinterpret the reported income. Instructors may wish to explore possible
variations with their students.
Relates to Expanded Material.
246
Chapter 10
SOLUTIONS TO STOP & THINK

Stop & Think (p. 572): The 2001 current ratio of McDonalds is only 0.81; does this mean that
McDonalds will not be able to meet its current obligations as they come due? Explain.
The current ratio is just one indicator of a companys ability to meet its current obligations. Another
indicator is the ability of the company to generate operating cash flow. In fact, from a conceptual
standpoint, current obligations are satisfied with normal ongoing operating cash flow rather than through
the liquidation of a companys existing current assets. Because McDonalds has the ability to generate a
stable stream of operating cash flow, it is still able to meet its current obligations even though its current
ratio is 0.81.
Stop & Think (p. 584): In computing the market price for bonds, what is the only thing the stated rate of
interest is used for?
Do not confuse the market and the stated rates. The stated rate is used only for computing the amount of
the interest payments. The market rate is used for computing the present value amounts of the principal
and interest payments.
Stop & Think (p. 590): When preparing a bond amortization schedule like the one illustrated below,
there are certain numbers within that schedule that you know without having to do any elaborate
computations. Identify what those numbers represent.
There are quite a few things you know about a bond amortization schedule before you actually prepare it
in detail. First, you know the amount of the periodic interest payments. Second, you know that the bonds
initial carrying value is equal to its present value on the day it was sold (its market value). Third, you
know that the bonds carrying value at the end of the life of the bond is going to be equal to the face
value of the bond.
Stop & Think (p. 607): How can there be a gain or loss on disposal but only a gain on restructuring?
The gain or loss on disposal of an asset is computed by comparing the carrying value with its market
value. The market value could be more than or less than book value. Regarding the restructuring, there
can be a gain only for the debtor. Remember what we are doing here: getting the creditor to forgive the
debt. That means the debtor will be able to retire debt at less than its carrying value. The debtor is
getting a good dealand this good deal is classified as a gain.
SOLUTIONS TO STOP & RESEARCH

Stop & Research (p. 572): Compare the current ratios in Exhibit 103 to each companys current ratio in
its most recent annual report. Do you note any systematic pattern in how those current ratios have
changed over time? Explain.
SOLUTION: Comparing the ratios in Exhibit 103 to the ratios for the same companies in 1998 reveals
an interesting pattern
Coca-Cola
Delta Air Lines
Dow Chemical
IBM
McDonalds
Microsoft
Wal-Mart
2001
0.85
0.56
1.27
1.21
0.81
3.56
1.04
1998
0.74
0.50
1.18
1.15
0.52
2.32
1.26
Six of the seven companies reported an increase in current ratio from 1998 to 2001. This probably
reflects the economic uncertainty during that three-year interval. As a result of the uncertainty, all of the
companies (except Wal-Mart, which seems to do well no matter what the condition of the overall
economy) felt the need to have a little bit more liquidity cushion.
Stop & Research (p. 600): What has the FASB done about the accounting for special-purpose entities
since this chapter was written? (Hint: Visit the FASBs Web site at http://www.fasb.org.)
An example of the FASBs response to the criticism of SPE accounting in the wake of the Enron scandal
is as follows:
On Wednesday, May 22, 2002, at 9:30 a.m., the FASB held an Open Meeting of the Financial
Accounting Standards Board with the number one item on the agenda being as follows:
Consolidations: interpretive guidance for certain situations. The Board will continue its discussion of a
draft of a proposed Interpretation of FASB Statement No. 94, Consolidation of All Majority-Owned
Subsidiaries, and Accounting Research Bulletin No. 51, Consolidated Financial Statements, that would
address issues related to identifying and accounting for special-purpose entities.
248
Chapter 10
SOLUTION TO NET WORK EXERCISE

Net Work Exercise (p. 582):
1. The Bonds Online Web site provides free information about bonds, links to other bond-related Web
sites, and the chance to establish an account for bond trading. For example, through the Bonds Online
Web site, one can learn about corporate bonds, municipal bonds, treasury bonds, zero-coupon bonds,
and bond ratings.
2. The Bond Professor provided a response to the following question: What is your overall opinion of
convertible bonds in todays market?
While I personally havent done much with converts in recent years, I have a warm place in my heart for
them. One of my early jobs was as a convert analyst and loan arranger at 5 to 10% margin. Our clients
really were swingers back in the early 1960s. My first articles were on converts. I view converts as
essentially a substitute for annuity. If you like a stock then you should check to see if it has a convertible
affiliated with it. If so, then get the terms of the convert and make an analysis. Does it offer a satisfactory
potential return for the risk? Is it nearly as good as the common or is it overpriced? Some of the things to
check are the conversion premium; call provisions; conversion premium recovery period; estimated
value as a straight bond, i.e. one without a conversion option.
Check out the conversion features to see if there is a step-up in the conversion price or does the
conversion option expire shortly. I would also look at the size of the issue, as I prefer (others may have
different views) issues of at least $100 million outstanding and listing on the NYSE. Some may leave out
the NYSE listing and say an OTC issue is okay. In looking at LYONS or similar zero coupon converts the
conventional premium recovery period isnt applicable, as the bonds dont pay current interest. With a
LYON, if the stock doesnt move then the conversion premium is steadily increasing. You may also want
to check out usable bonds. These are straight bonds that can be used in lieu of cash on the exercise of
warrants. These two together make a synthetic convert.
An article in the Financial Analysts Journal for Jan/Feb 1996 says in part:
From 1962 through September 1994, convertible bonds returned more than low-grade bonds but at a
higher standard deviation of return. After adjusting for bond and stock market movements, convertible
bonds outperformed low-grade bonds, but not at commonly accepted statistical levels of significance.
Convertible bonds are more sensitive to stock market movements and less sensitive to bond market
movements than low-grade bonds. Given the additional equity call option embedded in convertible
bonds, they should behave more like stocks and less like bonds. In addition, like low-grade bonds,
convertible bonds display a strong January effect. Good luck with your converts. Dont forget that there
are convertible preferred issues. Remember, if you like the stock, check to see if there is a convert.
Investigate before you invest.
SOLUTIONS TO BOXED ITEMS

Will IBM Be Around in 100 Years? (pp. 586587)
1. Low interest rates have created a market that encourages companies to lock in the low rates for long
periods of time. Even though investors risk in such bonds is high and interest rates are low,
investors are willing to invest in such bonds from quality companies even with an interest rate that is
only slightly higher than the rate on U.S. Treasury bonds.
2. The primary disadvantage to the issuer of very-long-term bonds, such as IBM or Disney, is that if
rates go lower, they would end up paying a higher rate of interest than the market rate. However, the
probability of lower rates was perceived by IBM and Disney as being low enough that the issuance of
bonds is worth the small risk.
3. An economist for Moodys Investors Service Inc. stated that investors in the Disney bonds will need
to have a lot of confidence in the longevity of Mickey Mouse. The Disney issue will provide
investors with a fixed return for 100 years, assuming, of course, that Disney remains in business that
long. Another reason for investors interest in such long-term bonds, as stated by one investor, is to
lengthen the average maturity of their bond holdings in order to counterbalance short-term holdings.
The Largest U.S. Corporate Bond Issue Ever (pp. 594595)
1. The effective interest rate on U.S. corporate bonds is higher than the rate on U.S. Treasury
securities because the corporate bonds are riskier. The higher rate represents the risk premium that
U.S. corporations must pay investors in order to get the investors to lend money to them instead of
to the U.S. government. The interest rate on U.S. Treasury securities is often referred to as the riskfree rate.
2. Investors buy bonds instead of, or in addition to, stocks because even though the yield on bonds is
generally lower than the expected yield on stocks, this is balanced by the fact that there is less risk
associated with bonds than with stocks. Bondholders receive their required cash payments before
any cash can be distributed to stockholders.
3. Junk bonds are high-risk, high-yield bonds issued by companies whose credit ratings place them in
the below investment grade category. The RJR Holdings bond issue was made in connection with a
leveraged buyout of RJR Nabisco.
250
Chapter 10
COMPETENCY ENHANCEMENT OPPORTUNITIES

Deciphering 101 (The Walt Disney Company)
1. The largest liability in Disneys 2001 balance sheet is long-term borrowings totaling $8,940
million.
2. Disneys total borrowings in 2000 and 2001 are as follows:
Current portion
Other borrowings
Total borrowings
2001
2000
$ 829
8,940
$ 9,769
$ 2,502
6,959
$ 9,461
Total borrowings increased by only 3.3% in 2001 [($9,769 $9,461)/$9,461].

The current ratios in 2001 and 2000 are 1.13 and 0.90, respectively. Thus, the decrease in shortterm borrowing led to an increase in Disneys current ratio.
3. In Note 5, we see that U.S. dollar notes and debentures constituted 91.3% of Disneys total
borrowings in 2001.
Deciphering 102 (Boston Celtics)
1. Deferred Game Revenues results when the Celtics receive cash in advance of a service being
provided. This liability represents the portion of season ticket payments that has been received by
the Celtics but which has not yet been earned through the playing of games.
2. In some cases when athletes negotiate their contracts, the contract stipulates that a portion of the
current years salary be paid in the future, often after the player has retired. This amount is included
as a liability because it relates to the current (or past) periods performance. This account does not
represent amounts to be paid in the future for future years performances.
3. Total assets as of June 30, 2001 were $26,161,019 ($31,231,706 + $50,000,000 + $5,182,821
$60,253,508). Because total partners capital is a negative amount, we can see that total liabilities
are in excess of total assets.
4. The amount of recorded assets is just half of the amount owed on the $50 million note. As noted, the
partners capital account shows a deficit of $60 million. However, these numbers are based on the
reported assets and liabilities. The reputation, name, and membership in the NBA of the Boston
Celtics are all assets that are not reported in the balance sheet at current market value. However, as
lenders consider making loans to the Celtics, they do consider these economic assets. Thus, the
company is able to continue to function even though reported liabilities are in excess of reported
assets.
Deciphering 103 (Hewlett-Packard & Compaq)
1. Hewlett-Packards current ratio in 2001 is 1.53. Compaqs current ratio in 2001 is 1.19. Thus, HP
appears to be the more liquid of the two companies.
2. HPs debt-to-equity ratio is 1.34 when debt is defined as total liabilities. Compaqs ratio is 1.13 using
the same definition. Thus, HP has more debt relative to stockholders equity.
3. For HP, current liabilities are 75.0% of total liabilities. For Compaq, current liabilities are 88.6% of
total liabilities. It appears that HP has more long-term debt in its financing mix.
4. Hewlett-Packard has a larger retained earnings balance primarily because it has been in business a
lot longer than Compaq. HP was making calculators long before Compaq was a dream in its
founders mind.
Deciphering 104 (Philip Morris)

1. Philip Morriss current ratio for the year is 0.84 [$17,275/($20,141 + $512)]. The computation is made
a little more complex because Philip Morris reports its liabilities (and assets) in two segments,
consumer products and financial services.
2. Because Philip Morris has two distinct segments, it breaks down its assets and liabilities into these
two segments so that users of the financial statements can determine how the company has
allocated its assets and the liabilities associated with those assets. Many large companies with
multiple
segments provide similar disclosure. For example, both Ford and General Motors, with an
automobile
segment and a financing segment, do the same thing. In many cases, this disclosure is in the notes
to the financial statements.
3. a. Using only long-term debt in the computation, Philip Morriss debt-to-equity ratio is 0.95
[($17,159 + $1,492)/$19,620].
b. Using all the liabilities, the companys debt-to-equity ratio is 3.33 ($65,348/$19,620). The big
difference in the two numbers results from Philip Morris having a lot of liabilities other than just
long-term debt. The first question one should ask when interpreting a debt-to-equity ratio is, what
is the definition of debt being used?
Deciphering 105 (H. J. Heinz Company)
1. A Eurodollar note is a U.S. dollar-denominated note that is not a domestic note. A domestic note is
any note issued under the control of U.S. banking or other regulatory authorities. Initially, these types
of notes were primarily issued by European banks; hence, they were called Eurodollar notes.
However, the term is more general and represents any U.S. dollar-denominated note outside the
jurisdiction of U.S. authorities, whether issued by a European, Asian, South American, African, or
Australian bank.
2. A company may have debt denominated in foreign currency for a variety of reasons. Perhaps a
subsidiary of the company is located in a foreign country and the interest rates in that country make
it advantageous to issue debt there. Some countries place restrictions on investment by outsiders,
and as a result, funding must come from within the country. In addition, companies use other
currencies to hedge obligations or to protect themselves from currency risks or interest rate changes.
3. As you can see from the note, H. J. Heinz will need to come up with more than $1.0 billion in the
year 2021 to pay off debt that is maturing in that year. Rather than pay the debt in 2021, the
company may refinance the debt with additional debt issues.
SAMPLE CPA EXAM QUESTIONS
1. The correct answer is c. Since the bonds were issued at 109, or 109% of the face amount of
$1,000,000, the total proceeds were $1,090,000. The bonds included 50,000 detachable stock
purchase warrants with a value of $4 each for a total of $200,000. The remainder of the proceeds, or
$890,000, were attributed to the bonds. This results in a discount on bonds of $1,000,000
$890,000, or $110,000. This solution assumes that the value of the bonds without the warrants
cannot be separately determined.
2. The correct answer is a. Upon calling the 600 bonds at 102, Dome will pay $612,000 to retire the
bonds. The carrying value of the bonds is the face value of $600,000 plus the unamortized premium
of $65,000 for a total of $665,000. The difference is a gain on early extinguishment of debt equal to
$53,000.
252
Chapter 10
Writing Assignment: I like these no interest bonds.

1. Recall that traditional bonds consist of two parts: a lump sum distribution and an annuity. Each of
these parts is valued by the market when determining the market price of bonds. While not having to
make semiannual interest payments is appealing to a firm from a cash flow perspective, the lack of
interest payments also reduces the market value of the bond. Because there is no annuity associated
with a zero-interest bond, the market will reduce the price of the bond accordingly. Thus, the
proceeds from a zero-interest bond are often much less than those received from the sale of more
traditional debt instruments.
2. Zero-interest bonds:
Lump sum payment: Table II, 10%, 10 periods (0.3855 $100,000)................
Deferred-interest bonds:
Lump sum payment: Table II, 10%, 10 periods..................................................
Deferred interest payments:
Table II, 10%, period 6 (0.5645 $10,000)................................... $5,645
Table II, 10%, period 7 (0.5132 $10,000)...................................
5,132
Table II, 10%, period 8 (0.4665 $10,000)...................................
4,665
Table II, 10%, period 9 (0.4241 $10,000)...................................
4,241
Table II, 10%, period 10 (0.3855 $10,000).................................
3,855
Present value of bond........................................................................................
Traditional bonds:
Lump sum payment: Table II, 10%, 10 periods..................................................
Interest payments: Table IV, 10%, 10 periods (6.1446 $10,000)....................
Present value of bond...................................................................................
$38,550
$38,550
23,538
$62,088
$38,550
61,446
$99,996
3. As illustrated by this example, the interest terms associated with a debt instrument can significantly
affect the debts market value. Bonds that pay interest require periodic outflows of cash in the form
of interest, while zero-interest bonds require a large cash outflow only when the bonds are
redeemed. Zero-interest bonds are attractive because the cash outflow is often far into the future.
However, as the maturity date nears, firms often find themselves unprepared to make the cash
payment necessary to retire the debt.
Research Project: Foreign debtwhy and how?
The objective of this project is to get students to realize that companies obtain debt financing using a
variety of sources. Bond markets exist in numerous countries and U.S. companies are actively involved
in the debt markets of foreign countries. Students will have to go beyond the textbook in order to address
the issues raised in this assignment. Finance texts, international business texts, advanced accounting
texts, and/or professors in each of these areas might be of help as students address these questions.
A company might have some of its loans denominated in foreign currencies for a variety of reasons.
First, some countries are reluctant to allow large multinational corporations to do business in their
countries without using local financing. It helps the company establish good local relations if it uses local
financial institutions as much as possible. Also, many foreign subsidiaries of U.S. multinationals are
relatively self-contained, meaning that almost all operating, investing, and financing activities are
handled locally. Sometimes a multinational gets foreign currency financing because the interest rate is
low. Finally, foreign currency financing is a way for a multinational company to hedge, or protect itself,
again fluctuations in the value of foreign currencies. For example, if a U.S. company has assets
denominated in Thai baht, and the baht decreases in value, then the company will have lost money.
However, if the company has an equal amount of loans denominated in Thai baht, the loss from the
decrease in the value of the Thai baht assets will be offset by the gain from the decrease in value of the
Thai baht liabilities. This is called a hedge and results in the U.S. company being immune to the effects
of exchange rate changes, either up or down.
The Debate: Rules for ratios

The purpose of this exercise is to require students to think of the pros and cons associated with requiring
ratios to be computed in a certain way. Requiring the debt-to-equity ratio to be computed in a predefined
way would have advantages, but what way should that beinclude only long-term debt or include all
liabilities? Students should walk away from the debate realizing that a burden is placed on the user of
financial statement information to understand how information was compiled and computed. Rather than
mandate a computation, it is probably wiser to encourage users to ask the right questions when using
financial statement information.
Ethical Dilemma: Keeping our debt covenants
Debt covenants exist to protect the interests of debtholders. In some cases, these debt covenants might
cause managers to make decisions that are not in the best long-term interest of the company. In this
case, the Larsen brothers are asking you to manipulate the current ratio, not for a business purpose, but
instead to ensure that debt covenants are not violated. Now, one could argue that it is in the best interest
of the company to comply with the debt covenants and if it takes a little accounting magic to do so, then
so be it. Students should realize that accounting information is used for a variety of purposes and that
tracking profits and losses is only one purpose. Financial statements are also used to protect the
interests of many parties, debtholders in this case. Preparers of financial statements must keep the
interests of these other users in mind as they prepare financial statements.
Cumulative Spreadsheet Analysis
See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual.
Internet Search
1. The following numbers are from the 2001 financial statements of each company.
a.
b.
c.
d.
e.
f.
(in millions)
Total assets
Total liabilities
Total long-term debt
Total assets of finance subsidiary
Total liabilities of finance subsidiary
Long-term debt of finance subsidiary
General Electric
$495,023
434,984
79,806
425,484
392,627
79,091
General Motors
$323,969
303,516
163,912
193,759
177,345
153,186
Ford
$276,543
268,085
167,035
188,224
175,105
153,543
2. The following computations illustrate the impact of the finance subsidiaries on the reported leverage
position of General Electric, General Motors, and Ford:
Overall debt ratio (Total liabilities/Total assets)

Debt ratio without the finance subsidiary
Debt ratio of finance subsidiary alone
Overall long-term debt divided by equity
Long-term debt divided by equity
without finance subsidiary
Long-term debt divided by equity
of finance subsidiary alone
General
Electric
87.9%
60.9%
92.3%
General
Motors
93.7%
96.9%
91.5%
Ford
96.9%
105.3%
93.0%
1.33
8.01
19.75
0.03
2.66
-2.89
2.41
9.33
11.70
Each of the companies has a very high debt ratio. In addition, in each case, the large majority of the
companys long-term debt is associated with the finance subsidiary. It is interesting to note that for both
General Motors and Ford, the automotive segments (the remainder of the business after the finance
subsidiary is removed) also have very high debt ratios. In fact, for Ford, the automotive segment has
negative equity.

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CHAPTER 10

4. Generally, liabilities should be reported at

2. a. An executory contract is one in which

For each payment, a portion is interest and

a. Secured bonds have specific assets

bonds because of the favorable tax

10. The market rate of interest is the rate

using the effective-interest method. The

12. Three ways bonds may be retired prior to

gain or loss. For the investor, this could be

the benefits of these joint ventures are

Relates to Expanded Material

recognition of a gain or loss unless the

and the carrying value is recognized as

WORKING CAPITAL AND CURRENT RATIO

Working capital = Current assets Current liabilities = $2,150 $3,250 = ($1,100)

SHORT-TERM OBLIGATIONS EXPECTED TO BE REFINANCED

TOTAL COST OF LINE OF CREDIT

Credit line commitment fee: $100,000 0.0008 (12/12) = $80

COMPUTATION OF MONTHLY PAYMENTS

Business Calculator Keystrokes:

PRESENT VALUE OF FUTURE PAYMENTS

PMT = $1,887.88 (see the solution to Practice 104)

MARKET PRICE OF A BOND

MARKET PRICE OF A BOND

ACCOUNTING FOR ISSUANCE OF BONDS

ACCOUNTING FOR ISSUANCE OF BONDS

PRACTICE 1010 BOND ISSUANCE BETWEEN INTEREST DATES

PRACTICE 1011 STRAIGHT-LINE AMORTIZATION

Discount on Bonds Payable = ($100,000 $84,628)/30 = $512.40

PRACTICE 1012 EFFECTIVE-INTEREST AMORTIZATION

Interest Expense ($84,628 0.05)

Remaining carrying value of bond: $84,628.00 + $231.40 = $84,859.40

Remaining carrying value of bond: $84,859.40 + $242.97 = $85,102.37

PRACTICE 1014 MARKET REDEMPTION OF BONDS

PRACTICE 1015 ACCOUNTING FOR ISSUANCE OF CONVERTIBLE BONDS

Premium on Bonds Payable

PRACTICE 1016 ACCOUNTING FOR CONVERSION OF CONVERTIBLE BONDS

Paid-in capital in excess of par = ($55 $1 par) 2,000 = $108,000

Debt = All liabilities

Debt-to-equity ratio = $120,000/$90,000 = 1.33

Debt = All interest-bearing debt

Debt-to-equity ratio = ($10,000 + $70,000)/$90,000 = 0.89

Debt = Long-term, interest-bearing debt

Debt-to-equity ratio = $70,000/$90,000 = 0.78

Times interest earned ratio

PRACTICE 1020 DEBT RESTRUCTURING: EQUITY SWAP

PRACTICE 1021 DEBT RESTRUCTURING: SUBSTANTIAL MODIFICATION

PRACTICE 1022 DEBT RESTRUCTURING: SLIGHT MODIFICATION

Interest expense of $2,907 will be reported in 2005.

A mortgage liability of $46,235 ($50,000 $3,765) will be reported on the balance

(a) Present value of maturity value:

or with a business calculator:

or with a business calculator:

or with a business calculator:

or with a business calculator:

Interest Expense ($50,000 0.10 3/12).......

Gain on bond reacquisition:

(1) Straight-Line Method:

Dec. 31 Interest amount based on effective rate

Dec. 31 Interest amount based on effective rate

Bond InvestmentOldtown Corp..................

*Carrying value of bond investment: